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Currency Volatility Options and Monetary Policy

by Leonardo Reos, FRM

· Currency Markets,Derivatives,Monetary Policy

Option auctioning by central banks can bring stability and effectiveness in the currency markets and avoid persistent currency appreciation and depreciation, as demonstrated by the Colombia experiment. By implementing an USDCOL call auctions during peso depreciation and USDCOL put auctions during periods of peso appreciation can lead to trend reversal and less volatility in subsequent currency moves (ie. peso depreciation in the former and appreciation in the latter). These option auctions were triggered when exchange rate volatility met some threshold levels (usually between 2 and 5%).

However, these auctions were infrequent, lacked central bank currency exposure hedging and even if there was, a one-side hedging could give the wrong signal to the market.

Therefore a put/call spread W strategy for market intervention can be further implemented to better smooth out volatility and impact the spot and options markets, providing the CB with a strategic and protected position in the spot market, warranted on the lack of poor economic fundamentals and the CB unwillingness to maximize the potential unlimited gains of the strategy but rather just become part of a normal daily volatility placatory mechanism.

This strategy would involve combining two long USDCOL (ITM at K1 and OTM at K3) and one short USDCOL Call (ATM spot at K2) with two long USDCOL Puts (OTM at K1 and ITM at K3) and one short USDCOL Put (ATM spot at K2).

The tested strategy proved to smooth out variations in exchange rates. Besides the reduced net risk for the central bank by way of a smaller payoff position at maturity, the smaller net delta position is hedged providing the right market signal to correct USDCOL appreciation or depreciation (ie. selling USDCOL in peso depreciation trends and purchasing USDCOL in peso appreciation trends).

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