Estimation of Expected Exchange-Rate Change Using Forward Call Options

01/02/2003 |  Stein Roy
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The Foreign Exchange Market
Estimation of Expected Exchange-Rate Change
Using Forward Call Options

Roy Stein


The public's expectations of exchange-rate changes are an important economic variable in macroeconomic analysis,especially in regard to monetary developments and capital movements of the private sector.Several methods are used to derive expectations;the most accepted of them is based on the spread between domestic and foreign interest rates (the UIP principle).This method assumes implicitly that the risk premium is inconsequential.We argue that this component is in fact substantial and has been growing in recent years.There are several reasons for this,including the liberalization of Israel's forex-market and the introduction of greater flexibility in its exchange-rate regime,both of which have been engendering larger capital movements.The growth of the risk-premium component makes it more important to separate the risk premium from the interest spread in order to determine "net" expectations of exchange rate changes.

This study describes the risk premium and,by means of statistical tests,demonstrates its existence.In our opinion,any estimate of expectations of exchange-rate changes that disregards the risk premium is biased.We show that the magnitude of the risk premium is reflected in the price of the NIS–dollar options,issued by the Bank of Israel,at the forward-at the money strike price.This study concludes that by subtracting the risk-premium component one obtains an unbiased estimate of the public's expectations of exchange-rate change.

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