TY - JOUR T1 - How Rational Are the Option Prices of the Hong Kong Dollar Exchange Rate? JF - The Journal of Derivatives SP - 140 LP - 161 DO - 10.3905/jod.2020.1.120 VL - 28 IS - 3 AU - Samuel Drapeau AU - Tan Wang AU - Tao Wang Y1 - 2021/02/28 UR - https://pm-research.com/content/28/3/140.abstract N2 - 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, 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 article calls for better modeling of how investors formulate their beliefs. ER -