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Julian D. A. Wiseman
Abstract: Governments should reduce volatility in the foreign-exchange markets by committing themselves to frequent and regular auctions of short-dated physically-delivered FX options. Sale of an appropriately designed exotic option would further smooth the stabilisation.
Contents: PDF version, Publication History, Introduction, Hedging option holdings, Why can’t the central banks do their own delta-hedging?, Implementation details,
Publication history: based on sections 2 and 3 and the appendix of Mechanisms For Central Banking, June 1996, published by the Financial Markets Group of the London School of Economics, special paper number 84, ISSN 1359-9151-84, by the same author, with a foreword by Professor Charles A. E. Goodhart. Usual disclaimer and copyright terms apply.
Introduction
This paper describes a new FX-stabilisation mechanism.
In late 1992, sterling was ejected from the European exchange rate mechanism. Since then the United Kingdom has a strong political aversion to attempts to ‘manage’ the level of the currency. Because of this political aversion, it is important to emphasise the differences between that mechanism, and this proposal.
The new FX stabilisation mechanism proposed here is entirely different to that European ERM. That ERM could be likened to a brick wall: the price of the member currencies was not allowed cross certain thresholds. Eventually, the weight of speculative money overwhelmed the walls. In contrast, the mechanism proposed here is analogous to a field of tall grass. There are no fixed barriers that might test the credibility of the system. Instead, as the wind blows, the grass slows the wind by ‘absorbing’ its energy. Further, the central banks are fairly remunerated for providing this stabilisation.
Before describing the mechanics of the reduction of FX volatility, it should be asked whether the authorities would wish to reduce volatility? Yes: many politicians have complained that financial markets are excessively volatile, but very few have ever complained that they are insufficiently volatile. Financial intermediaries, who endeavour to make profits from the turnover that can be triggered by changes in prices, may well desire volatility, but when the elected or appointed authorities comment on volatility it is almost always to suggest that less would be better. How far should volatility be reduced? Obviously zero volatility means fixed prices, and this must be wrong when new information is constantly arriving into the market place. Given that all interested parties (with the exception of some of the intermediaries) seem to desire lower volatility, but that zero is too low, the natural course is to put in place a modest option-selling programme, and then to assess whether it was too much or too little. In any event, we proceed on the assumption that the authorities actively desire lower volatility.
The working of this mechanism is simple: governments should commit themselves to frequent and regular auctions of short-dated physically-delivered FX options.
Hedging option holdings
Why do official sales of options would reduce market volatility? The answer lies in the financial risks inherent in owning such an option.
Consider the position of a trader who owns one option, with two weeks to expiry, that gives the trader the right to buy £1 for ¥200 on the expiry date (a GBP call JPY put). Let us imagine that the pound is currently worth much less than the strike: say ¥180. Clearly, the option is almost worthless: why spend ¥200 on a pound (by exercising the option) when a pound can be bought at the cheaper price of ¥180 in the market. If the pound were to appreciate to ¥190, the option would still have only a small value. But if the pound were to appreciate to ¥200, the option would increase in value substantially, and if sterling were to increase to ¥210, then the option would be worth at least ¥10.
The point is that as £/¥ moves from below to above the strike, not only does the value of the option increase, but each additional ¥1 further move increases the value of the option by more than previous moves.
So a trader who is hedging this option exposure would start with little hedge, and whenever the pound rose the trader would sell a little more sterling. Likewise, as the pound falls, and particularly as the pound falls through the strike, the holder of the option would buy pounds.
It is stressed that this process of ‘delta-hedging’ is not just a theoretical construct; it is standard and necessary practice for option traders. It is inherent in the ownership of the option. Commercial banks are risk-averse, and option desks do not wish to acquire exposure to the underlying markets. If an option trader did have a directional view, the exposure given by the option would substitute for actively acquiring this position by chasing the market.
Indeed, if a particular option holder decided not to hedge its position as the market moves, then this would not hamper the stabilisation. Other private-sector banks would detect the reduced level of buying or selling in the broker and retail markets. They would deduce that there is trading to come, even if only after the expiry of the option, and would buy or sell in anticipation of this. In other words, private-sector banks would not only delta-hedge their own positions, they may also delta-hedge the others’.
In effect, official sales of options are a self-enforcing sub-contracting of FX market intervention, from the central banks to the highest bidder in the private-sector.
Why can’t the central banks do their own delta-hedging?
It has been suggested that this programme could be ‘simulated’ by the central banks; the central banks calculating the delta-hedges and executing them themselves, rather than incentivising the private sector to do so. There are two difficulties with such a central-bank role. First, delta-hedging is mostly ‘science’, but still involves a certain amount of judgement. If the market is thin, or has been temporarily manipulated, a trader may well decide to not to delta-hedge — at least for the moment. Thus an ‘automated’ delta-hedging programme, in which market moves automatically trigger intervention, would invite manipulation. Second, the Central Banks’ delta-hedging programme would require at least daily intervention. The Fed, ECB, BoJ and BoE would be active almost constantly in FX markets, and it would be difficult to signal credibly that the intervention was the whole delta-hedging and nothing but the delta-hedging. Hence the need for the central banks to ‘privatise’ the FX stabilisation (by the sale of options) rather than keeping it in-house.
Naturally, the recommended programme of option sales entails some implementation details.
Implementation details
It is envisaged that a multilateral group of central banks would jointly write a ‘model agreement’, covering such sales of options, to be signed by pairs of central banks. There would be an advantage if all the monetary-authority pairs signed the same type of agreement, with only the parameters varying from one pair to the next. If agreements are not the same then the market would suspect that the differences are important, with slight wording changes giving rise to doubts about the motivation for the difference.
It seems natural to envisage a central core of four currencies (USD, EUR, JPY and GBP), each of which is stabilised against the other three, the four central banks thus selling options on the six possible cross rates: €/$, $/¥, €/¥, £/$, €/£ and £/¥. Other currencies would be attached to this core in a manner appropriate to trade flows.
This model agreement should be public, as should each specific agreement between central banks. The model agreement should include a statement, explicitly non-binding, that both parties intend to announce any mutually agreed change to the agreement eight weeks before its implementation. But each party would have a right to cease further sales of options without notice — in the expectation that this clause would be invoked only in the event of default or war or similar manifest event.
Once an option is sold, it is irrevocably and unconditionally guaranteed by both parties, severally and jointly.
It might occur to policy-makers to issue options only in times of market instability. This would be unwise: the admission of panic would exacerbate volatility, and uncertainty about the sale of options would itself be a cause of speculation and volatility. Hence the model agreement should state that the parties have agreed to conduct auctions regularly, according to a pre-determined calendar. This calendar may well specify twice-weekly auctions.
For this policy to be most effective the private-sector banks need to own options that are near to expiry, and that have strikes near the current level of the market. This could not be done with auctions as infrequent as monthly or quarterly. The ideal situation would be for options with almost no time to expiry to be auctioned continuously, but this is impractical. Conducting twice-weekly auctions of options with fourteen or so days to expiry seems a reasonable compromise.
As an additional aid to ensuring that there are always options with strikes near the money, each auction could be of options with several strikes: say at-the-money, atm±σ and atm±2σ, for some suitable σ. It is possible to achieve this effect more smoothly and elegantly using the exotic option described in the appendix.
This scheme should only be implemented in widely-traded currency pairs, to ensure that the pool of potential bidders is sufficiently large that a cartel could not operate. All of the six cross rates between $, €, ¥ and £ easily satisfy this criterion.
It has been suggested that central-bank selling of options would inhibit private-sector selling, and that this is undesirable. Certainly the central banks would become the dominant provider of short-dated volatility. But this was the objective; financial markets being short volatility causes instability (in October 1998 the ‘street’ was very short of options on $/¥, and this short greatly exacerbated the explosive collapse in the dollar). However, the owners of the central-bank-provided options are likely to become keen sellers of both long- and short-dated volatility to the corporate sector, thus cheapening corporations’ cost of financial insurance.
There is a trade-off in this whole approach. Although the authorities will reduce the volatility of FX prices, they will increase the variability and unpredictability of their own FX reserves. Further, the authorities must not delta-hedge its short option positions, as to do so would necessitate the government selling into falling markets and buying into rising markets, undermining the whole purpose of the programme.
Central bank sales of options would reduce market volatility in a credible and sustainable manner, and central banks would be fairly remunerated for doing so. Sales of options would not only reduce actual FX volatility, but would also reduce non-financial corporations’ cost of hedging FX exposures.
Julian D. A. Wiseman, June 1996 and May 1999
The PDF version includes, as an appendix, a description of an exotic option use of which would improve the effectiveness of this FX regime.
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