European Economic Review, 1999 (forthcoming)
This paper analyses how to extract market expectations from asset prices, with a particular example: using the term structure of interest rates to estimate the probability the market attaches to the event that a country, Italy, joins the European Monetary Union at a given date. The extraction of such a probability from the term structure is based on the presumption that the term structure contains valuable information regarding the markets assessment of a countrys chances to join the EMU. The case of Italy is interesting because in the survey regularly conducted by Reuters the probability of joining EMU in 1999 fluctuated between 0.07 and 0.15, while, during the same period, the measures of computed by financial houses -- also based on the term structure of interest rates -- have ranged between 0.5 and 0.8. The paper proposes a new method for computing these probabilities, and shows that the discrepancies between survey and market-based measures are not the result of market ine fficiencies, but depend on an incorrect use of the term structure to compute probabilities. The technique proposed in the paper can also be used to distinguish between convergence of probabilities and convergence of fundamentals, that is to find out whether an observed reduction in interest rate spreads signals a higher probability of joining EMU at a given time, or simply reflects improved fundamentals.