Currency options are obviously useful as a risk-management tool. I feel that futures are nice simple linear contracts: they ask the person to make only one decision -- are you long or are you short. But once a futures position is entered into, the person needs the ability to manage the position since daily marking-to-market is done, and since there can be large losses for either the futures long or the futures short.
Compared with this, long positions on call or put options appeal to the kind of person that is willing to think carefully about a position at the outset, but after that it is fire and forget. This better describes the life of many firms exposed to currency risk, particularly those with relatively weak treasuries.
Currency options have, of course, been traded OTC for some time now. But there are real problems with this market. Customers have sometimes been ripped off by banks on pricing, given the lack of a liquid and transparent comparison point. While currency options are offered by banks to customers, there is not much by way of an inter-bank market.
As far as I know, there is relatively little by way of a build-up of human and systems capability in the banks for currency options trading (whether OTC or on exchange).
In contrast, there is a remarkable build-up of human and systems capability in the world of Nifty options trading. Options on Nifty have shaped up as one of the biggest options markets in the world. This involves end-users who think and trade options, staff working for securities firms who understand options (and understand issues about their credit risk when their customer has an options position), analytical software systems, and (most importantly) algorithmic trading systems. Options trading inevitably involves trading in a large number of underlyings. Strong computer systems which are able to think about, and place orders in, all the underlyings at one shot are of essence in achieving option liquidity. Such capabilities are now found in the world of Nifty options, and are absent in banks or in the OTC currency options market.
It is fairly easy for a person trading Nifty options to move to trading currency options. Hence, the brainpower and systems that have made Nifty options one of the world's top contracts will easily be able to move to currency options trading, and make it work. I expect that the securities firms who dominate Nifty options trading will now dominate currency options trading.
I think three kinds of stories will now kick in:
- Liquidity in currency options will fuel liquidity in currency futures, and vice versa. Corporate hedgers will be more interested in either, given that the other is also a possibility.
- Skills and systems from Nifty options will flow into currency options. Banks will be able to rapidly bulk up their options capabilities by recruiting from the world of Nifty options, and by purchasing the software systems that have sprung up in that space.
- Conversely, trading in both currency options and Nifty options will generate an increased business size for people who build knowledge and systems for options; it will also improve knowledge of options trading through an understanding and comparison of the nuances of two different underlyings. The number of FRM and PRM certified people in India will go up.
Of great interest will be the question of currency volatility. On one hand, the currency options market will generate an implied volatility for the currency, which will represent a market-based forecast for what future currency vol will be. This will be a big new piece of information which will inform macro policy and monetary policy, and thus diminish the extent to which we are flying blind in thinking about Indian macroeconomics.
In recent years, RBI has mostly stayed off from trading the currency market, so the volatility of the INR/USD is a true market volatility. If, in the future, RBI thinks that it wants to give subsidised currency risk management services to the private sector, one way in which it would be able to do that is to do `intervention' on the currency options market so as to force down the implied vol of the market. I.e., RBI would sell ATM calls and ATM puts and thus drive down that price, and thus give cheaper risk management services to the market. This would represent the first operational intervention strategy for RBI through which it can pursue the goal of reducing volatility without distorting the INR/USD exchange rate.
If RBI gets into actively trading the currency market again and trying to push the rupee into a de facto pegged exchange rate, we will see this clearly in the currency options market as a sharply reduced implied vol.
Excellent piece
ReplyDeleteI often find the posts by Dr. Ajay Shah to be interesting, informative or both. But, I think this must be the first time I have come across a post by Dr. Ajay Shah which may be characterised a technically weak at best. Let me explain:
ReplyDelete1. There is no substantiation for the assertion "...This better describes the life of many firms exposed to currency risk, particularly those with relatively weak treasuries." To have an options premium budget is considered a good practice (where affordable)world over. To think that "weak treasuries" use options while other treasuries use futures is incorrect factually (and also in a normative sense). If one insists on making a generalization, then at least factually the reality is exactly the opposite (though that canot be said in a normative sense).
2."...RBI thinks that it wants to give subsidised currency risk management services to the private sector, one way in which it would be able to do that is to do `intervention' on the currency options market so as to force down the implied vol of the market. I.e., RBI would sell ATM calls and ATM puts and thus drive down that price, and thus give cheaper risk management services to the market. " This idea is flawed for three reasons:
A. Underpricing options will make it unviable for commercial entities to sell options. It will kill the market.
B. An intervention is the options market will distort the volatility surface. Hence interpretation of INR or USD strength (on the basis of the volatility surface) will not be possible.
C. Even if option subsidies are desirable (i.e. if we ignore A and B)effective Subsidies are best provided in OTM options rather than ATM options.
Hello Dude,
ReplyDeleteThis is a great job!As we have already known the foreign exchange market is the largest and most liquid financial market in the world.Thanks for the compliment I am glad you like to the comments.I am really thankful to you for providing this unique information such as NSE and USE will start trading in currency options market.