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The author thanks Marcel Cassard, Burkhard Drees, Ronel Elul, Peter Garber, Laura Kodres, and Garry Schinasi for helpful comments and suggestions. The author also thanks Charles Adams, Myles Brennan, Guy Meredith, David Robinson, Bent Sorensen, several market participants and seminar participants at the Bank of England, the Board of Governors of the Federal Reserve System, the 1999 PACAP/FMI Finance Conference, the 1997 Southern Finance Association meetings, the University of Århus, and the World Bank for their comments. An investment bank in New York wishing to remain anonymous provided the data set on implied volatilities.
For example, a press report credits the use of Hong Kong dollar put/US dollar call options by the Bank of China in 1998 as a contributing factor for keeping the Hong Kong dollar peg intact (Risk, April 1999). Larry Summers stated in a speech on Global Integration (January 4, 1999) “[a]ny doubt I might have had about the globalization of economic thinking was shattered when I met with Chinese Premier Zhu Rhongi…I was asked a variety of searching questions about the possible use of put options in defending a currency, and how they might best be structured.” Banco de México introduced a currency option program in August 1996 designed to rebuild its foreign reserves.
This paper does not address the use of options to manage reserves. Some central banks may consider using options to protect the value of their foreign exchange reserves. The central bank would in that case be acting similar to an end-user such as a mutual fund, trying to protect the value of its portfolio.
The phrases “destabilizing” and “exacerbating volatility” are used interchangeably in this paper and imply a comparison between states with and without intervention.
The notional amount is the amount over which the contract is written and which will be exchanged if the option is exercised and if there is no cash settlement.
BIS (May 1999a). The survey covers 66 to 100 percent of all banks in 43 member countries, a total of 2787 institutions. It is estimated to encompass 95% of all worldwide foreign exchange activity.
Forwards and foreign exchange swaps amounted to 66 percent and currency swaps to 10 percent of the total of $22 trillion in notional amounts outstanding.
The gross market value of a portfolio of derivatives contracts is the sum of the (absolute) market values of the component contracts.
The difference between notional value and gross market value is that the former refers to the amount which underlies the derivatives contract whereas the latter is the sum of positive and negative replacement costs.
The relative importance of OTC currency options has increased since the last BIS survey in April 1995, when options represented only 8 percent of daily foreign exchange spot transactions.
A market participant is said to be ‘short’ an instrument if she sold it and ‘long’ an instrument if she bought it.
The net short position in currency options stayed constant in absolute terms but decreased by 1.7 percentage points between 1995 and 1998.
Furthermore, as is evident from the BIS survey, while market makers were net short options by a small amount, the flow of options actually reduced that short position even more. During the 1995 survey month dealers bought more options than they sold: on a net basis, average daily turnover of options bought exceeded that of options sold by $1.68 billion in the OTC market. In the 1998 survey, daily option purchases exceeded option sales on average by $14 million.
Variables which may vary across customers include currency pair, strike price, notional value and time to maturity.
As a put currency option is always a call option on the other currency in the pair, the first example in the preceding paragraph is sufficient. This paragraph merely provides a numerical illustration of stabilizing delta hedging.
In summary, market makers who are short gamma in the options market exacerbate volatility and market makers who are positive gamma reduce volatility.
A speculative attack may occur in a fixed exchange regime when market participants perceive the pegged exchange rate not to be in line with the fundamentals of the economy. See Flood and Garber (1994)
Since the scheme would have been designed as an insurance, the option would have to be an American option which could be exercised at any time during the life time of the option. Using a European option would imply the risk that the option position could not be liquidated at the desired time.
The calculations were conducted using the Bloomberg option valuation calculator which is based on binomial tree valuation procedures for American options.
Stochastic volatility models could be used for this pricing problem.
If the banks hedge the options dynamically losses should be limited. However, in that case the hedging activities increase volatility in the spot market. Furthermore, in a crisis dynamic hedging is virtually impossible. So, there would likely be some exposure by banks if there is a discontinuous movement in the exchange rate.
In fact, the losses would equal the central bank’s profit.
While drafting the current paper, the author became aware of a similar proposal put forward by Wiseman (1996) who primarily considers option auctions on government debt. See his paper for suggestions on how to conduct auctions.
We also note that implied volatility lags behind realized volatility and therefore is bound to perform poorly if used as the markets’ forecast of future volatility. A possible explanation for that could be that it takes time for market participants to realize the switch to a new regime.
In june 1997, the winning bids submitted ranged from MEX$20 to MEX$25 to MEX$25.01 with an average of MEX20.62.
Based on author’s conversations with maket participants.