The main objective of this study was to use the options market to derive exchange rates in a market where restrictions, controls, and government intervention may distort the equilibrium rates. A secondary objective was to look for a clue to expectations regarding a forthcoming devaluation. Since the foreign exchange options market in Israel is free of controls and intervention, we use it to make inferences regarding exchange rates and expectations of devaluation. Initially, we use options prices to derive the rate of exchange between the local currency (Israeli shekel) and the U.S. dollar. Then, we compute implied volatilities using three-month and 12-month option prices. The relative values of these implied volatilities may provide an indication of expectations of a devaluation. The findings are rather interesting. First, using three-month options, we found that the rate of exchange implied by option prices is indistinguishable from the rate established daily in the foreign exchange spot market (called the official rate), despite all the restrictions and interventions. However, when we used 12-month options, we obtained an implied rate that is different from the official rate. Thus, we cannot infer that the implied exchange rate is the equilibrium rate. All we can say is that the participants in the options market use the official rate to price three-month options but use a somewhat higher rate to price 12-month options. The difference between the two may be due to expectations of devaluation, more likely to happen in a 12-month period than in a three-month period. The devaluation issue was further investigated by analyzing the implied volatilities from both options. The spread between the implied volatilities of 12-month options and three-month options may provide an indication of the expectations of future devaluations, where an increase in the spread signals an increase in these expectations. Thus, immediately after a devaluation, the spread should increase since the likelihood of a devaluation in the next three-month period is much less than in the next 12 months. The data support these contentions.
All Science Journal Classification (ASJC) codes
- Economics and Econometrics