Arbitrage-Based Tests of Target Zone Credibility: Evidence from ERM Cross-Rate Options

José Manuel Campa · P. H. Kevin Chang

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Abstract

This paper introduces two arbitrage-based tests of target-zone credibility using a new data source, exchange-rate mechanism cross-rate options. Using daily option prices from September 1991 to August 1994, the authors assess the credibility of the pound-mark and mark-lira target zones that collapsed in September 1992 and the ongoing mark-French franc target zone. These tests are based on restrictions that must apply to all option prices within a credible target zone and are free from specification error and estimation error. The authors also identify a minimum 'intensity of realignment, ' an expression indicating the probability-weighted average realignment size. Copyright 1996 by American Economic Association.

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