Extracting information from exchange rate options in Brazil

Abstract

In this paper we extract risk neutral density probabilities for the Brazilian domestic exchange rate, from exchange rate options negotiated in the Brazilian market between 2000 and 2005. The focus is on implied volatility, skewness and kurtosis. Implied volatility and the forecasted density can be used to evaluate market expectations regarding the future evolution of exchange rate in the financial market. Implied skewness and kurtosis can be interpreted as measures of sentiment regarding the direction of changes and the occurrence of extreme events, respectively. These measures can be seen as forward-looking macroprudential indicators for the domestic financial system. The results obtained from the options market are compared with the density from surveys conducted with market economists by the Central Bank of Brazil, as we conclude that both expectations contain relevant information. The methodology of this paper can be generalized and applied to longer-term contracts and to different types of assets.