Hurd, Matthew, Salmon, Mark H. and Schleicher, Christoph (2005) Using copulas to construct bivariate foreign exchange distributions with an application to the sterling exchange rate index. Discussion Paper. London: Centre for Economic Policy Research (Great Britain). Discussion paper (Centre for Economic Policy Research (Great Britain)) (No.511).

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Abstract

We model the joint risk neutral distribution of the euro-sterling and the dollar-sterling exchange rates using option-implied marginal distributions that are connected via a copula function that satisfies the triangular no-arbitrage condition. We then derive a univariate distribution for a simplified sterling effective exchange rate index (ERI). Our results indicate that standard parametric copula functions, such as the commonly used Normal and Frank copulas, fail to capture the degree of asymmetry observed in the data. We overcome this problem by using a non-parametric dependence function in the form of a Bernstein copula, which is shown to produce a very close fit. We further give an example of how our approach can be used to price currency index options.

Item Type:	Working or Discussion Paper (Discussion Paper)
Subjects:	H Social Sciences > HB Economic Theory
Divisions:	Faculty of Social Sciences > Warwick Business School
Library of Congress Subject Headings (LCSH):	Copulas (Mathematical statistics), Distribution (Probability theory), Foreign exchange rates -- Mathematical models, Arbitrage
Series Name:	Discussion paper (Centre for Economic Policy Research (Great Britain))
Publisher:	Centre for Economic Policy Research (Great Britain)
Place of Publication:	London
Official Date:	June 2005
Dates:	Date Event June 2005 Published
Number:	No.511
Number of Pages:	35
Status:	Not Peer Reviewed
Access rights to Published version:	Open Access

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