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How Rational Are the Option Prices of the Hong Kong Dollar Exchange Rate?

Samuel Drapeau, Tan Wang and Tao Wang
The Journal of Derivatives Spring 2021, 28 (3) 140-161; DOI: https://doi.org/10.3905/jod.2020.1.120
Samuel Drapeau
is an associate professor in the School of Mathematical Sciences at Shanghai Jiao Tong University in Shanghai, China
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Tan Wang
is a professor at the Shanghai Advanced Institute of Finance at Shanghai Jiao Tong University in Shanghai, China
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Tao Wang
is a professor at the Shanghai Advanced Institute of Finance at Shanghai Jiao Tong University in Shanghai, China
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Abstract

The authors developed a simple regime-switching model of Hong Kong’s linked exchange rate and provide a formula for its option prices. The formula can be used to back out from option prices the implied risk-neutral probability of the abandonment of Hong Kong’s Linked Exchange Rate System. For the option price data for the period from July 1, 2005, to February 28, 2020, the risk-neutral probability is estimated to have a mean of 9.82%. When contrasted with the fact that Hong Kong’s Linked Exchange Rate System has not failed since 1983, the objective probability of that event is less than 0.1% even for high levels of risk aversion. Their finding suggests that although the abandonment of the Linked Exchange Rate System is a significant risk, it cannot explain the risk premium seen in the option prices.

TOPICS: Currency, derivatives, options

Key Findings

  • ▪ The data on HKD/USD exchange rate option prices are consistent with the view that the current pegged exchange rate regime in Hong Kong is not credible.

  • ▪ The premium implied in the option prices for hedging that risk seems excessively high.

  • ▪ The evidence documented in this article calls for better modeling of how investors formulate their beliefs.

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The Journal of Derivatives: 28 (3)
The Journal of Derivatives
Vol. 28, Issue 3
Spring 2021
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How Rational Are the Option Prices of the Hong Kong Dollar Exchange Rate?
Samuel Drapeau, Tan Wang, Tao Wang
The Journal of Derivatives Feb 2021, 28 (3) 140-161; DOI: 10.3905/jod.2020.1.120

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How Rational Are the Option Prices of the Hong Kong Dollar Exchange Rate?
Samuel Drapeau, Tan Wang, Tao Wang
The Journal of Derivatives Feb 2021, 28 (3) 140-161; DOI: 10.3905/jod.2020.1.120
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    • STYLIZED FACTS BASED ON MODEL CALIBRATION
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