PT  - JOURNAL ARTICLE
AU  - Samuel Drapeau
AU  - Tan Wang
AU  - Tao Wang
TI  - How Rational Are the Option Prices of Hong Kong Dollar Exchange Rate?
AID  - 10.3905/jod.2020.1.120
DP  - 2020 Nov 12
TA  - The Journal of Derivatives
PG  - jod.2020.1.120
4099  - https://pm-research.com/content/early/2020/11/12/jod.2020.1.120.short
4100  - https://pm-research.com/content/early/2020/11/12/jod.2020.1.120.full
AB  - We 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. Our 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, optionsKey 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 paper calls for a better modeling of how investors formulate their beliefs.