Survey_HMM_2005

Abstract

The majority of the intra-ERM derivatives trading is in the over-the-counter markets, and the data is not generally available to non-traders. The best publicly available data are for US dollar (US$) exchange rates which are traded in Philadelphia. We focus on the US Dollar/British Pound (US$/BP) and Dollar/French Franc (US$/FF) contracts. We have data for the years 1992 and 1993, which encompass both major ERM realignments. The US$ appears to be an adequate proxy for the DM. During September 1992, the DM depreciated by ?1.47% against the US$, while the BP depreciated ?11.51%. From July 1 to August 5, 1993, the DM was similarly stable, depreciating ?0.83%, while the Franc devalued by ?3.59% against the US$. Both American8 and European options are traded. The BP options are for 31, 250 Pounds, and the FF options are for 250, 000 Francs. We use daily closing option prices that are quoted in cents. Spot exchange rates are expressed as US$ per unit of foreign currency and are recorded contemporaneously with the closing trade. Foreign currency appreciation (depreciation) will increase the moneyness of a call (put) option. Interest rates are the Eurodeposit rates closest in maturity to the term of the option. To obtain a rough idea about the implied volatility pattern in the currency options, we look at sample averages. We sort the data into bins based on the strike/spot ratio, S/K, and compute implied volatilities using the Black-Scholes formula. In Figures 2 and 3 and , we plot the data for all of 1992 and 1993, for the FF and BP, respectively. Both appear to display the characteristic pattern, with the minima of the implied volatility at the money, and with higher implied volatilities in the two tails. For estimation purposes, we excluded options that were more than 10% in or out of the money and with volumes less than 5 contracts. This seemed to eliminate most data points with unreasonably high implied volatilities. For the Pound, we looked at options from 5 to 75 days to maturity.Because the data were thinner with the Franc, we utilized all maturities greater than 5 days. We will now try to infer whether changes in the smile signalled an impending crisis in the ERM.