RT Journal Article
SR Electronic
T1 How Rational Are the Option Prices of the Hong Kong Dollar Exchange Rate?
JF The Journal of Derivatives
FD Institutional Investor Journals
SP 140
OP 161
DO 10.3905/jod.2020.1.120
VO 28
IS 3
A1 Drapeau, Samuel
A1 Wang, Tan
A1 Wang, Tao
YR 2021
UL http://jod.pm-research.com/content/28/3/140.abstract
AB 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.