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 Samuel Drapeau A1 Tan Wang A1 Tao Wang YR 2021 UL https://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.