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Currency Options And Trade Smoothing Under An Exchange Rate Regime Shift

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  • Alexis Derviz

Abstract

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.

Suggested Citation

  • Alexis Derviz, 1999. "Currency Options And Trade Smoothing Under An Exchange Rate Regime Shift," Bulletin of the Czech Econometric Society, The Czech Econometric Society, vol. 6(9).
  • Handle: RePEc:czx:journl:v:6:y:1999:i:9:id:68
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    File URL: http://ces.utia.cas.cz/bulletin/index.php/bulletin/article/view/68
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    References listed on IDEAS

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    1. Dirk Tasche, 2004. "The single risk factor approach to capital charges in case of correlated loss given default rates," Papers cond-mat/0402390, arXiv.org, revised Feb 2004.
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    5. Jon Frye, 2000. "Depressing recoveries," Emerging Issues, Federal Reserve Bank of Chicago, issue Oct.
    6. Stefano Caselli & Stefano Gatti & Francesca Querci, 2008. "The Sensitivity of the Loss Given Default Rate to Systematic Risk: New Empirical Evidence on Bank Loans," Journal of Financial Services Research, Springer;Western Finance Association, vol. 34(1), pages 1-34, August.
    7. Seidler, Jakub & Horvath, Roman & JakubĂ­k, Petr, 2009. "Estimating expected loss given default in an emerging market: the case of Czech Republic," Journal of Financial Transformation, Capco Institute, vol. 27, pages 103-107.
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    More about this item

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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