Central Bank Participation in Currency Options Markets

IMF Working Papers, October 1, 1999

Source details

This paper analyzes whether and how central banks can use currency options to lower exchange rate volatility and maintain (implicit) target zones in foreign exchange markets.
It argues that selling rather than buying options will result in market makers dynamically hedging their long option exposure in a stabilizing manner, consistent with the first objective.
Selling a “strangle” allows a central bank to increase the credibility of its commitment to a target zone, and could have a lower expected cost than spot market interventions.
However, this strategy also exposes the central bank to an unlimited loss potential.

Central bank action: Participation via currency options, specifically option selling.
Market-maker response: Dynamic hedging of long option exposure by market makers leads to stabilizing effects on exchange rate movements.
Instrument compared: Option-selling (strangle) versus spot market interventions.
Cost and credibility trade-off:
- Potential benefit: Lower expected cost than spot market interventions.
- Risk: Unlimited loss potential for the central bank when selling options.

Consider selling option structures (e.g., a “strangle”) to:
- Lower exchange rate volatility.
- Increase credibility of an implicit target zone commitment.
- Potentially reduce expected intervention costs compared with spot interventions.
Manage and monitor unlimited loss exposure associated with option-selling strategies.

Central Bank Participation in Currency Options Markets - WP/99/140
- Central Bank Participation in Currency Options Markets - WP/99/140 (Markdown version)
- Central Bank Participation in Currency Options Markets - WP/99/140 (PDF)