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A Study on the Central Bank's Foreign Exchange Market Intervention Strategies with OTC Currency Option Market

중앙은행의 OTC 통화옵션시장을 활용한 외환시장 개입 전략에 관한 연구

  • Jae-Kwan Park (Department of Economics and Finance, Keimyung University)
  • 박재관 (계명대학교 경제금융학과 )
  • Received : 2022.03.27
  • Accepted : 2022.04.29
  • Published : 2022.04.30
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Abstract

This paper studies the possibility of options as an instrument for central bank to intervene foreign exchange market. As opposed to spot transaction or forward transaction, which impacts spot exchange rate only once, currency options can continuously resist a directional speculative pressure on spot market due to the dynamic delta hedging of OTC currency options market maker. This research also 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 short position rather than long position in 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. Therefore these kinds of intervention strategies must be used in the short run and temporarily.

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