BIS Paper Sees Some Evidence EUR/CHF Floor Break was Signalled

Given how
the EUR/CHF cross collapsed immediately following the removal of the pair’s artificial
floor by the Swiss National Bank (SNB) in January 2015, it would seem an
obvious answer to the question, “was the event expected” would be “no”. The
cross fell from its SNB-imposed floor at 1.2000, hitting 0.7000 at one stage
before the “official” low was set at 0.85, finally settling around 1.05.

A new paper
published by the Bank for International Settlements (BIS), however, studies
events in the FX market leading up to the removal of the EUR/CHF floor in
January 2015, and while it is not conclusive, it does find evidence that some
option markets were predicted the break lower in the cross.

The working
paper, The discontinuation of the EUR/CHF
minimum exchange rate in January 2015: was it expected?
was written by Michael
Funke, Julius Loermann and Richhild Moessner from the BIS Monetary and Economic

The authors
attempt to quantify how unexpected the removal of the exchange rate floor was. They
derive risk-neutral probability density functions (pdfs) for EUR/CHF rates as
implied by the prices of options with maturities of one to 12 months, using both
parametric and non-parametric approaches.

The study
shows the evolution of the probabilistic expectations, in the form of the
probability of breaching the Swiss franc floor (break probability), and the
associated higher-order moments (skewness and kurtosis), over the course of
several important market events and exchange rate regime changes.

It also
studies the forecasting performance of option-implied pdfs for EUR/CHF returns
during the time the floor was in place, considering the forecasting performance
of an error-correction model augmented with break probabilities in comparison
with a random walk benchmark model, as well as the forecasting performance of
the entire option-implied pdfs.

The authors
find that that financial markets attached “some credibility” to the Swiss franc
floor, since the break probabilities never significantly exceeded 50% while the
floor was in place, but especially at longer maturities there was some doubt.

probabilities increased from January 2014 for all maturities, suggesting that
the credibility of the Swiss franc floor somewhat decreased. “We also found
that the credibility of the Swiss franc floor decreased to some degree as the
spot exchange rate approached the lower bound of 1.20 CHF per euro,” the write.

economists argue that financial markets are an excellent window into future
developments and thus help us to understand economic policy and politics – but
markets are hardly omniscient. For example, they recently struggled to forecast
the Brexit vote,” they continue. “It is well-known that high-frequency exchange
rates are notoriously difficult to predict. The associated difficulties of such
an undertaking are neatly expressed in the following still valid phrase, ‘In my
judgement, a model that was consistently able to explain 10 percent of the
actual quarter-to-quarter changes in exchange rates … would be a successful
model. … A model that was able to explain more than 50 percent of quarter-to-
quarter changes in exchange rates should either be rejected on the grounds that
it is too good to be true or should be reported to the Vatican as a miracle
justifying the canonization of a new saint’.

“In this
paper we compared the forecasting performance of a random walk benchmark model
with an error-correction model (ECM) augmented with option-implied break
probabilities,” the authors add. “For the one-month parametric and
non-parametric break probabilities, we found some evidence that the ECM has an
informational advantage over the random walk, while we found that the ECM has
no informational advantage over the random walk for the three-month maturity.
Considering the forecasting performance of the option-implied pdfs, we found
that the one-month option-implied densities cannot predict the entire range of exchange
rate realisations.”



Colin Lambert

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