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Currency Target Zones as Mirrored Options

Sandro Claudio Lera, Matthias Leiss and Didier Sornette
The Journal of Derivatives Spring 2019, 26 (3) 53-67; DOI: https://doi.org/10.3905/jod.2019.26.3.053
Sandro Claudio Lera
is a postdoctoral fellow at the Massachusetts Institute of Technology in Cambridge, MA
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Matthias Leiss
is a postdoctoral researcher in the Department of Social Sciences of ETH Zurich in Zurich, Switzerland
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Didier Sornette
is a professor in the Department of Management, Technology, and Economics at ETH Zurich in Zurich, Switzerland, and a professor at the Swiss Finance Institute in Geneva, Switzerland
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Abstract

This article presents a new way of modeling the dynamics of an exchange rate target zone. In the presence of a single upper (lower) target boundary, the exchange rate is precisely represented as the sum of a free float and a short (long) position in a call (put) option with strike price at the boundary. To model a target zone (with two boundaries), a natural approach consists of describing the exchange rate dynamics as the combination of the two, namely the sum of free float together with a long position in a put written on the lower boundary and a short position in a call option written on the upper boundary, respectively. The authors show that this first order approximation leads to significant mispricing (as much as 20%) and must be iterated, leading to an infinite sequence of compounded “mirrored” option prices. They analyze basic properties of such mirrored nested options analytically, describe how to calculate them numerically, and show why it is crucial to take into account higher order corrections in realistic target zones. They argue that this analogy to option prices allows for conceptually simple generalizations that describe different target zone arrangements. They then apply their methodology to the estimation of the fundamental value of the Hong Kong dollar that is hidden by the target zone pegged to the US dollar. They also estimate the implied maturity and explain how this parameter serves as direct proxy for target zone credibility.

TOPICS: Interest-rate and currency swaps, statistical methods, options

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The Journal of Derivatives: 26 (3)
The Journal of Derivatives
Vol. 26, Issue 3
Spring 2019
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Currency Target Zones as Mirrored Options
Sandro Claudio Lera, Matthias Leiss, Didier Sornette
The Journal of Derivatives Feb 2019, 26 (3) 53-67; DOI: 10.3905/jod.2019.26.3.053

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Currency Target Zones as Mirrored Options
Sandro Claudio Lera, Matthias Leiss, Didier Sornette
The Journal of Derivatives Feb 2019, 26 (3) 53-67; DOI: 10.3905/jod.2019.26.3.053
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  • Article
    • Abstract
    • TARGET ZONES AS INFINITE SEQUENCES OF COMPOUND OPTIONS
    • ESTIMATING MATURITY AND FUNDAMENTAL VALUE
    • APPLICATION TO THE USD/HKD EXCHANGE RATE
    • CONCLUSIONS
    • ACKNOWLEDGMENTS
    • APPENDIX A
    • APPENDIX B
    • APPENDIX C
    • APPENDIX D
    • ENDNOTES
    • REFERENCES
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