Currency Options And Trade Smoothing Under An Exchange Rate Regime Shift
The paper introduces a transition from an exchange rate target zone to the free float in a dynamic general equilibrium model of production, trade and consumption under diffusion uncertainty in a small open economy. The loss of credibility and subsequent collapse of the target zone is modeled by means of an implicit market for American call optiolls on foreign currency with a common expiration date and the strike price equal to the upper bound of the zone. Options that would be out of the money forever and, therefore, never traded under a credible upper bound, start being transacted some time prior to the zone collapse. Agents active in the currency options market are international investors, domestic households and exporters. Households may use the options to finance consumption of imported goods out of currency acquired by exercising previously purchased calls. The exporters can write currency calls to be honored out of the future export revenues. The exchange rate first exceeds the target zone upper bound shortly prior to the currency optioll expiration time. Consumption of imports then exhibits a smooth transition to the post-expiration pattern: the demand for imports gradually rizes above the position implied by the spot exchange rate, to fall back smoothly to that position at the expiration date. Thus, in the presence of currency options households consume more of imported goods as they would without them.
Volume (Year): 6 (1999)
Issue (Month): 9 ()
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