Central bank participation in currency options markets

Abstract

This paper investigates whether central banks can participate in currency option markets to achieve their objectives of lowering volatility and possibly setting target zones in exchange rate markets. It argues that selling rather than buying options will result in market makers dynamically hedging their long option exposure in a stabilizing manner, consistent with the central banks objectives. Furthermore, selling a 'strangle' allows a central bank to create a target zone. The proposed scheme would lower the volatility of the exchange rate, could have a lower expected cost than spot market interventions and would provide the right incentives for a central bank to adhere to its target rate.