Currency Options as Central Bank Risk Management Tool

Preliminary version, April 2014

Helena Glebocki Keefe, Erick W. Rengifo

Fordham University, Economics Department

April 1, 2014

Abstract
Many central banks in emerging markets and developing economies are concerned with excessive
volatility in foreign exchange markets and wish to control the direction and speed with which the value
of their currency changes. Historically, intervention has consisted of using foreign exchange reserves to
purchase and sell foreign currency directly in the spot market. The research presented in this paper
explores how currency options may be a viable central bank tool for intervention. Holding and issuing
bundles of call and put options with multiple strike prices while dynamically delta hedging the portfolio position curbs excessive reserve accumulation, builds markets and domestic liquidity, establishes
a more effective signaling process between policy makers and the market, and creates a more cohesive
intervention plan than direct spot market intervention. We use the Garman-Kohlhagen options pricing
model to analyze the case study of Colombia and to simulate the impact of using an alternative to a
butterfly strategy as an intervention mechanism on the spot market position of the central bank, reserve
accumulation and total costs accrued from intervention1 .

The research conducted and presented in this paper has been sponsored by the Global Association of Risk Professionals.

Introduction

Holding2 and issuing3 bundles of call and put options while dynamically delta hedging4 the net portfolio
position allows central banks in developing economies to have a targeted approach to currency market
intervention. Previous attempts to use options as an intervention mechanism by Mexico and Colombia
have been abandoned. Deemed ineffective in curbing volatility by some, such as Mandeng (2003), past
failure of options contracts may be due to their sporadic and unhedged issuance, leading to little sustained
impact and no clear picture of how to operate in the spot market. This paper revisits the case of Colombia
to analyze how using an alternative to the butterfly option strategy can provide central banks with an
alternative policy tool to intervene in currency markets to control volatility, influence expectations, build
markets and ensure domestic liquidity at a lower cost than pure spot market intervention.
Central banks in emerging markets and developing economies are concerned with excessive fluctuations of their exchange rates. Such volatility can cause risks associated with banking crises, economic
instability, slowed growth and diminished trade. According to a survey by the Bank of International
Settlements of 19 central banks in developing economies, two-thirds conducted some type of currency
market intervention and found it to be an effective tool for controlling exchange rate volatility (Mihaljek,
2004). Most developing countries are engaging in some type of intervention into currency markets to
exert control over exchange rates. Many intervene to calm disorderly markets and relieve liquidity shortages, while others try to correct misalignment and stabilize volatile exchange rates. All policy makers
surveyed stated that intervention which influences future expectations and signals a future stance of
monetary policy is the most effective. Interventions are assumed to have primarily a short-term influence on currency markets. Since currency markets are very dynamic, even in emerging markets and
developing economies, the most effective strategy for the central bank will be one that is consistent.
Holding and issuing bundles of call and put options at various strike prices on a consistent basis
while dynamically delta hedging the portfolio position in the spot market will allow the central bank
to influence the expectations of traders, target volatility and signal their policy stance. It will also
provide policy makers with a clear target for operating in the spot market while increasing liquidity
domestically. Additionally, the costs associated with intervention will be lower, sterilization problems
2

Holding options contracts will refer to ownership of the contract. Specifically, when it is holding a contract, the central bank
will be long the option contract and have the right, but not the obligation to exercise the contract.
3
Issuing options contracts will refer to writing and auctioning the option contract. Specifically, when it is issuing a contract,
the central bank will be short the option contract and will be obligated to fulfill the contract if it is executed by the owner
at maturity.
4
Dynamic delta hedging is the main hedging strategy considered in this research because it reflects a short-run strategy of
intervention, which has been found to be most effective by policymakers (Mihaljek, 2004) and because drastic changes in day
to day value of the currency are not anticipated. An alternative strategy, such as gamma hedging will be considered in future
research that builds on the current findings.

will be alleviated, and signals between traders and the central bank will allow policy makers more time
to react to speculative threats and deviations of the exchange rate from macroeconomic fundamentals.
This paper explores how options may be a viable alternative policy tool for central banks in developing
economies to use in currency market intervention. First, we analyze Colombias past experimentation
with options contracts as the baseline case. Next, we explore which option strategies are most appropriate
to meet the goals of central bank currency market intervention. For the analytical approach, we use both
a random process and an Ornstein-Uhlenbeck process with GARCH volatility to simulate the Colombian
Peso-US Dollar (COPUSD) exchange rate. With the simulated series, we price options contracts at
various strike prices and analyze the outcome of hedging a portfolio position that is tailored to counter
persistent appreciation or depreciation in the exchange rate. We compare the spot market position and
total costs to the central bank of such a strategy with the cost of daily interventions currently conducted
by Colombia.
The remaining sections of the chapter are structured as follows. Sections two presents an overview
of options and basic strategies. Section three lays out the motivation for research and a review of the
literature. Section four presents the data and historical analysis for the case of Colombia. Section five
addresses the possible option strategies that are most effective to the goals of the central bank. Section
six presents the analytical approach, models and methodology for simulation. Section seven reports
the simulation results. Section eight discusses implications of the findings and future extensions of the
research.

Overview of Options

An options contract provides the owner the right, but not the obligation, to exercise their position at
the given strike price. In other words, a call (put) option offers the owner the right to buy (sell) the
underlying asset at the given strike price on or before maturity of the contract from the writer or issuer
of the contract. A call (put) option will be exercised when the spot market price at the end of the
contract is above (below) the strike price.
To be long in an option contract is to have purchased the contract, and therefore hold the right to
exercise the option upon maturity. To be short in an option is to have written or sold the option contract
to a market participant.
As can be seen in Figure (1), a long call option has limited downside risk when the value of the
underlying asset changes (S) but unlimited payoffs with an increase in the value of S. As the value of
the underlying asset increases, the owner of the call option will be able to exercise the option at the

agreed upon strike price (K). He is therefore able to buy the asset at a lower price than market value,
in turn buying low, selling high. His downside risk is limited to the premium he must pay to own the
contract if the contract is not exercised. In contrast, a short call option has unlimited downside risk
and limited payoffs. The payoffs of a short call are limited to the premium received by the writer of
the contract when the call is not exercised. As the value of the underlying asset increases, the writer of
the call option is obligated to sell the underlying asset to the owner of the contract (the one in the long
position) at the strike price, which is below the market value of the asset. He is therefore selling low,
buying high, which puts him in a position of unlimited loss as the asset value rises.
On the other side of the market, a long put option has limited downside risk as well as limited
payoffs. The owner of the put option has the right to sell the underlying asset at the strike price K to
the writer of the contract. The long put option will be exercised if the value of the underlying asset
(S) is below the strike price (K). In this scenario, the owner of the long put option sells the asset at a
price higher than the market value to the writer of the contract. He is therefore selling high, buying
low. The downside risk of the long put option is limit to the premium the agent must pay for the right
to own the contract, even if the contract is not exercised. The writer of the contract has a short put
option position, and is also faced with limited payoffs and large but limited downside risks. He will be
obligated to buy the underlying asset from the owner of the contract at the strike price K. Once again,
his payoff is limited to the premium he receives if the contract is not exercised.

Figure 1: Call and Put Option Strategies

The above figure illustrates call and put option positions and payoffs. The value of the underlying asset in the spot market is represented by S and the
strike price of the option is K. Long calls have unlimited gains, and limited losses, whereas long puts have limited gains and limited losses. Short calls have
unlimited losses and limited gains, whereas short puts have limited gains and unlimited losses.

In the context of the foreign exchange market, a currency call option on US dollars (USD) in Colombia
(COP) gives the owner the right to buy USD from the writer of the contract at the strike price. The

owner of the contract is long a call option in this case. Therefore, the call option will be exercised if the
spot exchange rate of COPUSD is above the strike price, or in other words, COP has depreciated since
the issuance of the option. On the other hand, a put option on USD in Colombia gives the owner the
right to sell USD to the writer of the contract at the strike price. In other words, the owner is long a
put option and the writer of the contract is short a put option. If the put option is exercised, then the
spot price at maturity has fallen below the strike price and COP has appreciated in value.
Currency option contracts are beneficial for traders and hedgers alike because they mitigate some of
the risk of drastic movements in the future value of the exchange rate. Market participants interested
in further offsetting risks associated with long or short options positions can also engage in dynamic
delta hedging, which allows them to continuously rebalance their portfolio in the the underlying asset
(DeRosa, 2011).
As explained in Chen (1998), the standard technique for a trader to hedge their position in the
options market against the risk of changing prices is referred to as dynamic delta hedging. Traders are
able to reduce risks associated with the movement in the price of the underlying asset by taking an
offsetting position in the spot market. For small movements in the exchange rate, the value of the hedge
will change in an equal but opposite direction. The delta is the responsiveness of the price of the option
to changes in the value of the underlying asset. The delta of an option will change as the contract nears
expiration or when implied volatility or the exchange rate changes. As the delta changes, traders will
adjust their offsetting position through buying or selling the underlying asset.
For a long call option, the offsetting delta hedging position in the spot market will be to short the
underlying asset. When an owner of the long call wants to hedge his position, he will sell a given amount
of the underlying asset directly in the spot market. The amount sold is determined by the delta of the
option at the time of hedging. Therefore, if the contract is for USD, the owner will sell USD in the spot
market. For a short call option, an offsetting delta hedging position in the spot market will be to long
the underlying asset. For the writer of the contract, he will purchase a given amount of the underlying
asset in the spot market to hedge his option contract position. If the contract is in USD, he will buy
USD in the spot market.
For a long put option, the offsetting delta hedging position in the spot market will be to long the
underlying asset. For a contract in USD, the owner of a put option will purchase a given amount of
USD in the spot market. The size of the purchase will be determined by the delta of the contract at the
time of hedging. For a short put option, the writer of the contract will offset his position in the options
market by selling the underlying asset in the spot market. For a contract in USD, the writer of the
contract will sell a given amount of USD in the spot market to hedge his short put option position. Once

again, the size of the offsetting spot market position is determined by the delta, or the responsiveness
of the option price to changes in the value of the underlying asset at the time of hedging.
By taking an offsetting position in the spot market, agents that are dynamically delta hedging their
options contracts should theoretically cover their hedging costs by the premium or payoff they gain from
the option contract. Even if the contract is not exercised, through consistent daily or weekly hedging,
the agent will be able to purchase or sell off the underlying asset over the period to maturity and cover
his costs with the premium or payoff derived from the option contract. Dynamically delta hedging allows
the agent to hold a neutral portfolio position with lower costs than relying solely on the spot market or
options market.

Literature Review

The following section will first delve into details on the currency options market and past literature
that has addressed how they can be used by central banks. It will then detail literature on central
bank intervention into foreign exchange markets in general. Finally, it will address macroeconomic
fundamentals that influence exchange rate movements as well as the linkages between inflation targeting
goals and exchange rates in emerging markets.

3.1

Currency Options

Currency options are used by various agents in the foreign exchange market, including currency traders,
speculators, hedgers and portfolio managers. The options market is mainly an interbank over-the-counter
market. The majority of currency options are European, meaning the option can only be exercised at
expiration (DeRosa, 2011). The global daily average turnover on a net-net basis5 in the foreign exchange
market in April 2013 was US$ 5.3 trillion, of which spot transactions were 38 percent and options were
less than 6 percent. Net-gross daily turnover6 in emerging markets made up roughly 6 percent of the
global foreign exchange market (BIS, 2013).3
If the central bank is the main writer of options, it can crowd out all other writers who may engage
in dynamic delta hedging that is potentially destabilizing (HKMA, 2000). Breuer (1999) argues that if
market makers are net long positions, their dynamic delta hedging behavior can lower volatility. When
option buyers purchase domestic currency in the spot market to hedge their positions when the currency
5

Net-net basis adjusts for local and cross-border inter-dealer double-counting

Net-gross basis adjusts for only local inter-dealer double-counting
3
This omits Singapore and Hong Kong turnover. Including these two would increase the share of turnover in emerging markets
to 40.2 percent
6

is depreciating, and sell it when it is appreciating, this will help stabilize exchange rates. In other
words, given the option is written for USD, in a long call a delta hedging position would sell USD
when the domestic currency is depreciating and buy USD when it is appreciating, therefore canceling
out volatile pressure. Archer (2005) argues that the transparency with which the central bank auctions
options contracts to market participants introduces stability and additional hedging instruments into
the market. Therefore, central bank use of currency options can be effective in stabilizing the foreign
exchange market and controlling volatility when it influences market liquidity and expectations.
The Hong Kong Monetary authority notes that options contracts can lower costs of hedging risk,
enhance the liquidity of the underlying asset and work to stabilize the foreign exchange market when
issued by the central bank (HKMA, 2000). Options contracts issued by the central bank can mitigate
the destabilizing dynamic delta hedging behavior that would otherwise be conducted by private market
participants in reaction to changing market conditions.
Authors such as Garber and Spencer (1995) and Grossman and Zhou (1996) have found a positive
link between dynamic delta hedging and spot market volatility. Therefore, one risk central banks must
consider when writing options contracts while dynamically delta hedging their position is that such
hedging activity may amplify the appreciation or depreciation pressure on the exchange rate, which
is contrary to the objectives of the central bank. The authors take into consideration only one-sided
positions, such as issuing only calls or only puts. The alternative butterfly strategy position, or issuing
both calls and puts, establishes a net hedging position that is smaller than a one-sided position in the
market, and therefore will be less destabilizing.
As HKMA (2000) notes, this stabilization will occur even if the amount of options contracts sold
remains constant because the price of the option changes in response to changes in the market value of
the domestic currency. When the central bank is holding a long position in the domestic currency (or
a short position in USD), as market pressures increase, the central banks long position increases while
the option buyers hold an offsetting short position. This would have a similar impact as a spot market
intervention. The effectiveness of this strategy will depend on the extent to which market participants
dynamically hedge their positions, and whether the size of the options contracts are large enough to
have a significant impact.
Wiseman (1999) argues that governments should commit themselves to frequent and regular auctions
of short-dated physically-delivered currency options as a mechanism to stabilize exchange rates. Since
almost all central bank authorities would like to reduce exchange rate volatility, without pushing it all
the way to zero, official auctions would encourage private banks to buy options and exercise them when
profitable. dynamic delta hedging on the part of the trader will substitute for actively pursuing the

same position in the market.

3.2

Central Bank Currency Market Intervention

The main goals of the central bank when intervening in currency markets are to smooth exchange
rate volatility, supply liquidity into foreign exchange markets and to control the amount of foreign
exchange reserves (Moreno, 2005). The broad motives for intervention are driven by macroeconomic
goals, such as inflation targeting, maintaining economic stability and competitiveness, preventing crises
and boosting growth. Acosta-Ormaechea and Coble (2011) find that in emerging markets with high
levels of dollarization and a strong exchange rate pass through, inflation targeting is more effective
through policies that target exchange rates rather than interest rates.
There are four main channels through which the central bank can intervene into currency markets
(Archer, 2005). First, in the monetary channel, changes in the domestic interest rate relative to the
foreign interest rate can alter the value of the domestic currency. This occurs through a change in
the domestic monetary policy. Next, in the portfolio balance channel, relative scarcity of the domestic
currency to the foreign currency can appreciate the value of the domestic currency. Here the central
bank intervention into the spot market determines the relative scarcity or abundance of the domestic
currency, in turn directly influencing the value of the nominal exchange rate. Third, through the signaling
and expectations channel, the central bank can shape expectations on future monetary and exchange
rate policy. Influencing expectations through the promise of future intervention can curb speculative
behavior and coordinate the direction of the currency towards equilibrium. The credibility of the signal
is also critical. Signals to control appreciation tend to be more credible than those to curb depreciation.
Lastly, in the order flow channel, the central bank tracks order flows to predict subsequent price action.
Central bankers can alter the order flow with their own orders that must be large relative to the total
market turnover. Due to less liquidity in the market and better access to information on order flows,
this channel may be more effective in emerging markets than advanced economies.
Canales-Kriljenko (2003) finds that in emerging markets and developing economies, 82 percent of
interventions take place in the spot market because this is the main or only currency market in the
economy. If the intervention is unsterilized, it can directly influence the direction of nominal exchange
rates through the monetary channel. If sterilized, the intervention will affect volatility through expectations and by attempting to curb speculative behavior. The success of the latter interventions in lowering
volatility has been questionable (Breuer, 1999).
Sterilized spot market interventions involve exchange rate intervention by the central bank without
any change in the countrys monetary base. The intervention occurs through the buying and selling

of domestic and foreign bonds by the central bank (Weber, 1986). The primary purpose of sterilized
interventions has been to counter appreciation of the domestic currency in fixed or managed float exchange rate regimes without impacting real exchange rates to diminish inflationary pressure coming from
changes in foreign currency inflows (Agenor, 2004).
Weber (1986) finds that from a theoretical perspective, sterilized interventions can in fact influence
exchange rates if bonds denominated in different currencies are not perfect substitutes, but empirical evidence from the US indicates that sterilized interventions do not impact exchange rates. Craig
and Humpage (2001) agree that such interventions have been ineffective because they do not affect
macroeconomic fundamentals and instead influence expectations and perceptions, whereas unsterilized
interventions can conflict with price stabilization but are unnecessary because the same effect can be
achieved through open market operations.
In terms of the size, frequency and timing of intervention, Mihaljek (2004) cites that when the
goal of the intervention is to influence the exchange rate, central banks find larger and less frequent
interventions to be more effective. In contrast, when the goal is reserve accumulation, frequent but
smaller interventions are more successful. Emerging market policy makers viewed small and less frequent
interventions as more likely to be successful than large but less frequent interventions.
Over the last decade, emerging markets have experienced a significant increase in international financial flows. Even though these flows are generally beneficial in terms of growth and welfare enhancement,
emerging markets frequently experience surges or sudden stops in flows, creating economic instability.
Such volatile flows contribute to large fluctuations in exchange rates, fueling of domestic asset bubbles,
poor resource allocation, balance sheet risks and banking or financial crises. One way central banks have
created a buffer against the downside of surges and sudden stops has been the build up of reserves and
intervention directly in the spot market (IMF, 2010).

3.3

Macroeconomic Fundamentals, Inflation Targeting and Exchange Rates

The value of one countrys currency reflects the markets expectation about current and future macroeconomic conditions, and therefore reacts to changes in macroeconomic fundamentals, such as trade,
monetary policy, balance of payments, aggregate demand and aggregate supply (Obstfeld and Rogoff,
1999). Many theoretical models have linked exchange rate movements to changes in macroeconomic
conditions. These include the monetary model presented in Dornbusch (1976) where an increase in
the money supply decreases domestic interest rates to adjust for the excess supply of real money balances. Through the uncovered interest rate parity, the decrease in the domestic interest rate requires
a change in the nominal exchange rate. Due to short run sticky prices, the depreciation in the short

run is larger than in the long run equilibrium. In portfolio balance model presented in Dornbusch and
Fischer (1980), the exchange rate determines the equilibrium between domestic money, domestic bonds
and foreign bonds. Changes in money supply or supply of bonds will drive changes in the exchange rates
to maintain equilibrium. An increase in the supply of domestic bonds, an increase in the foreign interest
rate, or expectation of future depreciation will result in a depreciation of the domestic currency. An
increase the supply of foreign bonds or an increase in the domestic interest rate result in an appreciation
of the domestic currency.
Inflation targeting has been adopted by a number of both emerging and advanced economies over
the last two decades. Even though it has been considered advantageous as a framework for monetary
policy, the macroeconomic effects of inflation targeting in empirical terms have been limited (Levin,
Natalucci and Piger, 2004). In industrialized economies, inflation targeting has been most effective in
controlling long run inflation expectations and lowering the persistence of inflation. Fraga, Goldajn
and Minella (2003) argue that emerging markets face more acute trade-offs when choosing the design
of their inflation targeting monetary policy, including higher output and inflation volatility. Due to a
more volatile macroeconomic environment, the implementation and commitment to inflation targeting
becomes more difficult in emerging markets than in advanced economies.
The impact of exchange rates on inflation targets and on monetary policy goals has been a concern
for many emerging economies due to the weaker financial system and their susceptibility to external
shocks. Stone, Roger, Nordstrom, Shimizu, Kisinbay and Restrepo (2009) argue that the exchange rate
is more important as a policy tool for inflation-targeting emerging markets than for their counterparts
in advanced economies for a number of reasons. In emerging markets, a high exchange rate passthrough indicates lower policy credibility and translates to a closer link between price and exchange rate
movements. Additionally, less developed financial systems in these countries correspond to more rigidity
in currency markets, which amplifies the impact of exchange rate shocks on the domestic economy.
Intervention into currency markets reflects the desire of central banks in emerging markets to mitigate
the impact of short-term currency fluctuations on output. Finally, active management of the exchange
rate is seen as a way to promote financial stability, which can also minimize the negative impact of
sudden stops in foreign currency inflows.
In contrast, Sek (2008) finds that the reaction of monetary policy7 to exchange rate shocks in three
inflation-targeting East Asian economies has declined after the East Asian crisis.6 A high exchange
rate pass-through in emerging markets makes it more difficult for central banks to target low inflation
rates and maintain price stability (Minella, de Freitas, Goldfajn and Muinhos, 2003, Fraga et al., 2003).
7
6

The monetary policy measures used include money demand (M1), short-term interest rates, output gap, and inflation
The three economies are Thailand, Korea and Philippines.

10

Reyes (2013) argues that the lower pass-through effect is a natural reaction to the implementation of
inflation-targeting policies in emerging economies, but the effects of nominal exchange rate fluctuations
on inflation rates can still be felt. If the pass-through effect is on the decline, this may explain why Sek
finds a lower reaction of monetary policy to exchange rate shocks post-crisis.
An appreciation of the domestic currency can lead to lower output and inflation in future periods
due to expenditure switching and because import prices will not rise as quickly with the appreciation
(Taylor, 2001). The reaction of interest rates to an appreciation is indirect as interest rates react to
changes in inflation and real GDP instead of directly to fluctuations in the exchange rate. Taylor
concludes the reaction of policy makers to changes in the exchange rate by adjusting interest rates may
not improve performance because this mechanism is already build into the policy rule indirectly and
because the reaction may make swings in real output and inflation even worse. Additionally, changes
in exchange rates under floating exchange rate regimes may indicate changing productivity and should
not be negated.

Historical Analysis of Issuing Options: The Case of Colombia

Colombia has experimented with many different intervention tools in its recent history. The Colombian central bank began systemic currency market intervention following the introduction of a floating
exchange rate regime and adoption on inflation-targeting monetary policy in 1999 (Uribe and Toro,
2005). It first started with the introduction of currency options for the purposes of reserve accumulation
and later to control for volatility. From 2000 to 2012, the average yearly purchase of US dollars by
the Colombian Central Bank was US$ 2.2 billion8 , or an average of 1.7 percent of market transactions
(Echavarria, Melo, Tellez and Villamizar, 2013). From 2005 to 2007 as well as from 2010 to 2012, the
purchase of US dollars by the central bank was much larger, the latter reflecting a change in policy to
daily discretionary purchases.
Trading of Colombias currency represents approximately 0.05 percent of all currencies traded on a
net-gross basis, amounting to daily average trades of US$ 3.34 billion in 2013. The domestic interbank
forex market makes up only 25 percent of the total market for COPUSD. Domestic foreign exchange
markets in Chile and Peru represent similar characteristics, as can be seen in Table (1). As discussed
above, the majority of domestic forex transactions are interbank transactions. In Chile, for example,
interbank spot market transactions make up approximately 52 percent of all domestic spot transactions.2
8
2

Sales were smaller at US$ 571 million

Based on data from Central Bank of Chile. Data from statistics on forex trading in the formal market. Represents sum of
interbank transactions, total sales and total purchases in USD in Chile in 2013.

11

Table 1: Foreign Exchange Markets: Global vs. Domestic

Global
Domestic

Global
Domestic

Global
Domestic

Amount (USD Mil)

Percent World Total
Amount (USD Mil)
Percent of Total Traded

Colombia
2004
802
0.03%
396
49.38%

2007
1,860
0.04%
780
41.93%

2010
2,794
0.06%
1041
37.26%

2013
3,343
0.05%
845
25.28%

Amount (USD Mil)

Percent World Total
Amount (USD Mil)
Percent of Total Traded

Chile
2004
2,462
0.09%
1,295
52.59%

2007
4,003
0.09%
1,698
42.42%

2010
5,544
0.11%
1,518
27.38%

2013
11,956
0.18%
2,488
20.81%

Amount (USD Mil)

Percent World Total
Amount (USD Mil)
Percent of Total Traded

Peru
2004
306
0.01%
81
26.39%

2007
805
0.02%
140
17.42%

2010
1,425
0.03 %
477
33.50%

2013
2,171
0.03%
841
38.72%

Global amount traded reflects average daily net-gross transactions. Domestic amount traded reflects interbank trading volume as
reported by the central banks. Data for global transactions from Bank of International Settlements.

The Colombian peso has been experiencing steady appreciation since 2009. From 2002 to 2009, it
experienced a number of periods with high volatility, where the bid-ask prices on the market exchange
rate were notably different official exchange rate. Figure (2) illustrates the differences between the bid
price, ask price, and official exchange rate in Colombia from 2002 to 2014, as well as the differences
between the official rates and bid or ask prices. Since 2012, the spread between official rates and market
prices has been much lower than in previous periods.
Colombia is one of the few countries to date that have auctioned call and put options to mitigate
exchange rate volatility and accumulate reserves. For the purposes of reserve accumulation and decumulation, the central bank auctioned options contracts on a monthly basis. The options were exercised
when the exchange rate appreciated or depreciated over than 20-day moving average mean, and the
amount to be auctioned in the subsequent month was determined at the end of each contract.
The volatility options with 30-day maturity were auctioned whenever the exchange rate changed
more that 4 percent of the 20-day moving average. The maximum exercise amount was US$ 180 million.
From 1999 to 2009, there were a total of 38 options contracts auctioned by the Colombian central bank.
The options intervention strategy was abandoned when the central bank switched intervention strategies
to a daily discrete intervention plan, where the central bank purchased an average of US$ 20 million
per day. From August 2012, the amount purchased varied from US$ 20 million to US$ 50 million daily.
The average intervention was 3.72 percent of total USD traded in the Colombian FOREX market, with

12

Figure 2: Colombian Peso Dynamics

The top graph represents the value of the official COPUSD exchange rate, the bid price and the ask price in the market. The bottom graph illustrates the
difference between the official exchange rate and the market exchange rates (bid price and ask price). The spread between official and market rates has
diminished in recent years. Market rates from OANDA. Official exchange rate data from Banco Republica de Colombia.

13

a maximum intervention that totaled 33.6 percent of the market volume.

The auction of options contracts in Colombia were fully transparent and the benefits of these auctions
were derived from the hedging operations of market participants (Uribe and Toro, 2005). When issuing
options contracts, the main objectives of the central bank were to avoid excessive volatility in the
exchange rate in a way that would uphold inflation targets, to strengthen the international liquidity
position domestically, and smooth any deviations of the exchange rate from its long run trend. From
2000 to 2005, call options were deemed successful in influencing both the value of foreign exchange rate
and the volatility. The call options were able to mitigate the increasing depreciation trend in 2003 that
threatened inflation targets. Mandeng (2003) finds that volatility call options issued until 2003 were only
moderately successful. On the other hand, Uribe and Toro (2005) state that put options were successful
in the accumulation of reserves from 1999 to 2002. They also find that Colombias intervention policies
have been largely consistent with its goals of inflation targeting, such that changes in monetary policy
came first through interest rates, and then through intervention in currency markets.
Starting in 2008, the Colombian central bank began purchasing US$ 20 million daily, first for two
months in 2008, then in 2010 for five months, in 2011 for six months, and every month since 2012.
Following the policies of Chile and Israel for daily discretionary intervention, US$ 20 million is the
average of the daily purchases in those countries (Echavarria et al., 2013). Colombia abandoned the use
of options-based intervention once it began the daily purchase of US dollars. The change in policy has
been considered a good mechanism for accumulating reserves without promoting speculative behavior
because it is a consistent and transparent intervention.
Mandeng (2003) uses an event study to observe the impact of auctioning three call options on
exchange rate volatility, comparing the volatility before and after the time of maturity. At the time of
his paper, Colombia had only issued these three options as a means to control volatility, and Mandeng
finds them to be only slightly successful in lowering volatility. Using a similar approach, Table (2)
illustrates the same analysis for all the call and put options issued since 2002. Volatility is measured
as the annualized standard deviation of the log difference in daily exchange rates over a 10 day rolling
window. Comparing volatility 2, 5, and 10 days before and after the contract maturity yields similar
results, where volatility is successfully lowered only in 30 to 40 percent of the cases.
In Table (3) the volatility calculation spans a two day, five day and ten day window depending on
which period is observed. Volatility is measured as the annualized standard deviation of the log difference
in daily exchange rates with a rolling window of 2, 5, and 10 days. With this calculation volatility after
contract expiration compared to volatility at the time of maturity is lower in 52 to 58 percent of the
cases. Using the latter calculation with different rolling windows captures the volatility in exchange rates

14

related specifically to the period that is being observed. The previous calculation compares volatility
that includes exchange rates before, during, and after maturity, yielding misleading results.
Part of the reason that past volatility options contracts were only moderately successful in lowering
volatility in Colombia may be due to their sporadic issuance that went unhedged. Figures (3) and (4)
illustrate intervention with put options and call options respectively. The sporadic issuance of options
yields inconsistent results in lowering volatility. The benefits of greater liquidity, building markets
and increasing the flow of information between policy makers and traders occur when auctions of the
contracts occur consistently, as discussed in (Breuer, 1999).
Additionally, the Central Bank only issued either calls or puts, not bundles of calls and puts at
different strike prices. Auctioning bundles of calls and puts at different strike prices, while holding an
offsetting position increases the information flow between policy makers and traders of expectations,
lowers the chances of speculative attacks9 , and mitigates some of the costs of hedging. The net hedging
position is lower for a mixed portfolio, therefore the position of the central bank in the spot market is
less disruptive than if it took only one side of the market. Though the Colombian central bank issued
only one side of the market at a time, there is no evidence that it engaged in dynamic delta hedging to
offset the risks associated with issuing volatility options.
In Tables (4) and (5), a simple regression tests the impact of the volatility options on the change in
the value of COPUSD from the day before maturity to the day the contract was exercised(t-1 to t), and
from the day of exercise to one day after maturity (t to t+1). The issuance of volatility calls options
had a significant, contemporaneous effect on exchange rate value at the time of maturity. At the day
of exercise of the call options, the change in COPUSD from the previous day was lower. The issuance
of volatility put options had a lagged effect on the exchange rate value. The exercise of put options
impacted the difference in value of the COPUSD the following day. In Table (5), the dummy variable
represents the size of the option relative to the total volume traded in one day. If the exercised volume
at maturity was greater than 20 percent of total volume, the dummy variable took on the value of one,
otherwise zero. Taking into consideration the relative size of the intervention did not significantly alter
the results, which may reflect the influence of volatility options through the expectations channel rather
than through the portfolio balance channel.
9

Speculative attacks in currency markets occur when there is a massive sell off of a particular currency, leading to a significant
depreciation or devaluation of the currency, depending on whether the exchange rate regime is floating or fixed.

15

Table 2: Volatility Options Contracts Issued in Colombia - Part 1

Date
17-Dec-04
11-Jul-06
31-Jul-06
10-Aug-06
30-Oct-06
21-Dec-06
30-Mar-07
3-May-07
15-May-07
4-Jun-07
20-Sep-07
11-Dec-07
15-Jan-08
20-Feb-08
25-Mar-08
4-Jun-08
18-Dec-08
17-Mar-09
27-Apr-09
3-Jun-09
22-Jul-09
Date
29-Jul-02
01-Aug-02
02-Oct-02
10-Apr-06
16-May-06
18-May-06
23-May-06
25-May-06
27-Jun-06
26-Jun-07
13-Aug-07
22-Nov-07
07-Oct-08
24-Oct-08
30-Jan-09
02-Feb-09
12-Feb-09

Put Options
Volatility Before
Volatility After
10 Days
5 Days
2 Days
2 Days
5 Days
10 Days
4.57%
5.14%
5.0%
5.46%
4.75%
6.93%
15.94%
13.81%
14.14%
13.50%
15.83%
11.27%
11.27%
13.90%
13.93%
9.56%
9.99%
9.21%
14.17%
9.99%
7.77%
9.00%
6.75%
4.86%
2.81%
5.31%
4.22%
3.89%
4.32%
5.83%
3.64%
3.01%
3.14%
4.14%
4.21%
3.22%
4.37%
7.22%
6.21%
11.30%
12.37%
11.58%
7.75%
7.06%
3.15%
5.51%
7.45%
9.76%
5.51%
10.31%
9.76%
11.49%
8.18%
9.04%
9.04%
12.56%
15.05%
12.77%
15.80%
9.40%
9.00%
14.04%
10.23%
19.59%
19.91%
14.09%
12.51%
11.66%
9.09%
8.11%
6.73%
5.44%
5.63%
4.25%
6.75%
13.16%
15.25%
18.77%
8.25%
7.55%
6.91%
10.98%
10.41%
11.94%
18.50%
16.72%
13.10%
15.26%
9.82%
11.15%
5.64%
5.89%
5.20%
7.39%
7.81%
10.10%
3.87%
9.37%
8.38%
14.47%
15.35%
6.61%
12.93%
14.71%
12.31%
16.06%
17.80%
21.00%
11.84%
16.53%
16.61%
19.96%
18.32%
18.46%
11.60%
12.88%
14.93%
17.18%
16.20%
14.27%
12.37%
17.85%
16.27%
13.69%
11.87%
24.92%
Call Options
Exercised
Volatility Before
Volatility After
USD Mil 10 Days
5 Days
2 Days
2 Days
5 Days
10 Days
180.0
9.28%
9.90%
11.23%
10.55%
8.45%
6.57%
109.5
8.50%
10.63%
10.55%
6.14%
6.57%
20.24%
124.5
7.00%
10.70%
9.87%
9.72%
8.75%
6.25%
168.5
2.87%
4.08%
8.62%
10.52%
10.16%
10.98%
179.8
7.46%
6.49%
11.84%
17.90%
14.57%
13.37%
179.8
3.42%
11.86%
16.60%
15.34%
15.92%
16.88%
179.9
11.86%
17.90%
14.57%
16.25%
16.88%
13.01%
179.9
11.79%
15.34%
15.92%
17.57%
16.62%
12.78%
56.4
11.30%
9.96%
7.72%
7.19%
15.93 %
13.92%
176.5
13.13%
17.10%
16.28%
17.45 %
11.00%
10.41%
179.9
10.95%
8.62%
8.23%
9.01%
9.39%
5.38%
12.5
5.02%
9.35%
8.81%
10.57%
6.78%
10.81%
174.9
47.27%
32.35%
26.48%
34.99%
41.28%
49.22%
59.7
39.20%
46.64%
41.88%
24.36%
21.19%
11.89%
180.0
8.40%
12.32%
11.30%
15.13%
15.61%
14.12%
180.0
9.43%
11.30%
15.07%
15.61%
17.55%
17.43%
8.5
15.29%
17.55%
11.87%
18.07%
15.86%
15.81%
Exercised
USD Mil
179.9
180.0
180.0
33.8
180.0
10.0
0.0
180.0
180.0
14.5
180.0
0.0
102.7
168.0
62.5
180.0
2.3
179.0
0.0
180.0
179.5

Short
Lower
Lower
Lower
Lower
Lower
Lower

Success
Mid
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower

Long
Lower
Lower
Lower
Lower
Lower
Lower
-

Short
Lower
Lower
Lower
Lower
Lower
Lower
-

Success
Mid
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower

Long
Lower
Lower
Lower
Lower
Lower
-

Volatility is measured as the annualized standard deviation of the log difference in daily exchange rates over a 10 day rolling
window. Using this calculation to test whether volatility is lowered after the option is exercised yields only moderately
successful results partly because it accounts of movements in the exchange rate before, during and after the contract
maturity.

16

Table 3: Volatility Options Contracts Issued in Colombia - Part 2

(2)
1.10%
18.34%
0.00%
12.84%
0.00%
5.33%
7.62%
12.24%
18.20%
0.00%
40.66%
4.66%
24.67%
10.41%
0.00%
10.42%
11.55%
30.36%
0.00%
1.05%
13.85%

Volatility at Maturity
(5)
(10)
9.97%
10.19%
13.68%
11.11%
10.43%
14.17%
8.61%
9.21%
5.47%
4.29%
5.24%
4.34%
5.39%
6.76%
7.53%
5.82%
10.86%
11.94%
17.37%
14.65%
27.97%
20.43%
5.29%
8.25%
15.47%
12.06%
9.01%
7.31%
0.00%
12.69%
7.63%
6.15%
18.34%
14.09%
18.51%
16.46%
8.38%
15.26%
19.55%
17.48%
10.28%
14.96%

Put Options
Volatility After
2 days
5 days
10 days
2.45%
10.91%
22.23%
14.70%
9.51%
11.27%
5.22%
4.09%
9.21%
4.83%
2.91%
4.86%
4.39%
4.09%
4.17%
2.76%
1.90%
3.22%
21.91%
17.03%
11.58%
0.05%
7.66%
9.76%
0.21%
4.14%
9.04%
0.32%
11.99%
9.40%
2.48%
8.03%
14.09%
1.40%
7.62%
5.44%
8.36%
12.47%
18.77%
24.88%
12.72%
11.94%
24.45%
14.70%
11.15%
13.33%
8.88%
10.10%
12.20%
5.13%
6.61%
4.44%
17.57%
21.00%
20.20%
24.92%
18.46%
1.25%
3.42%
14.27%
7.38%
14.13%
24.92%

2 days
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower

Success
5 days
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower
-

10 days
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower
-

(2)
0.00%
7.41%
5.67%
0.00%
27.25%
21.13%
22.66%
17.38%
0.00%
11.29%
0.00%
10.68%
55.54%
20.84%
8.42%
0.00%
0.26%

Volatility at Maturity
(5)
(10)
10.43%
10.59%
7.89%
10.25%
10.59%
11.44%
10.46%
8.80%
16.50%
16.60%
19.50%
17.90%
13.76%
15.92%
15.72%
16.25%
9.39%
7.07%
13.89%
14.45%
18.11%
12.70%
8.03%
10.13%
40.19%
33.43%
28.82%
44.15%
16.65%
14.44%
16.76%
15.29%
18.14%
17.43%

Call Options
Volatility After
2 days
5 days
10 days
11.46%
7.07%
6.57%
2.60%
6.28%
6.25%
4.31%
11.33%
9.76%
15.29%
7.75%
10.98%
21.13%
11.51%
13.37%
15.17%
8.71%
17.57%
17.38%
24.77%
16.62%
22.08%
19.10%
15.32%
0.84%
20.48%
13.92%
8.19%
14.58%
10.26%
19.09%
32.76%
27.18%
8.85%
5.52%
10.81%
31.23%
47.03%
49.22%
14.50%
10.01%
14.69%
18.93%
15.11%
14.12%
20.85%
17.45%
17.43%
3.81%
6.17%
15.81%

2 days
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower
-

Success
5 days
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower

10 days
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower
Lower

Date
17-Dec-04
11-Jul-06
31-Jul-06
10-Aug-06
30-Oct-06
21-Dec-06
30-Mar-07
03-May-07
15-May-07
04-Jun-07
20-Sep-07
11-Dec-07
15-Jan-08
20-Feb-08
25-Mar-08
04-Jun-08
18-Dec-08
17-Mar-09
27-Apr-09
03-Jun-09
22-Jul-09

Date
29-Jul-02
01-Aug-02
02-Oct-02
10-Apr-06
16-May-06
18-May-06
23-May-06
25-May-06
27-Jun-06
26-Jun-07
13-Aug-07
22-Nov-07
07-Oct-08
24-Oct-08
30-Jan-09
02-Feb-09
12-Feb-09

Volatility is measured as the annualized standard deviation of the log difference in daily exchange rates with a rolling window of 2, 5,
and 10 days. Comparing volatility at the time of maturity to 2, 5, and 10 days after maturity yields more successful results. After the
option is exercised, volatility decreases in 52 to 58 percent of all cases.

17

Figure 3: Volatility Put Options Interventions

Data from Banco Republica de Colombia.

Figure 4: Volatility Call Options Interventions

Data from Banco Republica de Colombia.

18

Table 4: Impact of Options Issued on COPUSD

Dependent Variable: Change in COPUSD (t-1 to t)
Calls
Puts
C
12.90**
0.02
(2.07)
(0.23)
Amount Issued (Calls)
-0.0717**
(2.07)
Amount Issued (Puts)
-0.0002
(-0.35)
R2
0.22
0.10
17
21
N.obs
Dependent Variable: Change in COPUSD (t to t+1)
Calls
Puts
C
-3.12
0.15***
(0.81)
(2.64)
0.02
Amount Issued (Calls)
(0.82)
Amount Issued (Puts)
-0.0009***
(2.62)
R2
0.04
0.27
N.obs
17
21
The dependent variable is the change in exchange rate value of COPUSD during time of option maturity.
It is calculated as the [St /St1 ] 1. The maturity of put options has a lagged impact on the exchange
rate, whereas the maturity of call options has a contemporaneous impact on the exchange rate.

Table 5: Impact of Options Issued on COPUSD with Dummy

Dependent Variable: Change in COPUSD (t-1 to t)
Calls
Puts
C
12.42*
0.03
(1.94)
(0.30)
Amount Issued (Calls)
-0.007*
(-1.94)
Amount Issued (Puts)
-0.0002
(-0.35)
Dummy
-0.003
0.0015
(0.63)
(0.37)
R2
N.obs

0.24
0.01
17
21
Dependent Variable: Change in COPUSD (t to t+1)
Calls
Puts
C
-2.88
0.15**
(0.73)
(2.43)
Amount Issued (Calls)
0.016
(0.73)
Amount Issued (Puts)
-0.0008**
(2.39)
Dummy
0.0015
- 0.0017
(0.62)
(0.60)
R2
N.obs

0.06
17

0.28
21

The dependent variable is the change in exchange rate value of COPUSD during time of option maturity.
It is calculated as the [St /St1 ]1. The maturity of put options has a lagged impact on the exchange rate,
whereas the maturity of call options has a contemporaneous impact on the exchange rate. The dummy
variable represents the size of the option relative to the total volume traded in one day. If the exercised
volume at maturity was greater than 20 percent of total volume, the dummy variable took on the value
of one, otherwise zero. The values in parenthesis are t-statistics, and *, **, *** represent significance of
10, 5, and 1 percent.

19

Trading Strategies for the Central Bank

As seen Figure (1) above, holding only one side of the market, either call or put, would expose the
central bank to risks associated with a drastic movement in the exchange rate that can be caused by
speculative attacks or macroeconomic fundamentals. Because the central bank is such a large player in
the market, hedging one side of the market may introduce adverse signals to traders. The central bank
has the means to move the market in its favor. Therefore, market participants may be weary to enter
into contracts with the central bank if there are any incentives for or suspicions of market manipulation.
Entering into long contracts in either the put or call position will expose the currency market to
excessive volatility through the hedging behavior of the traders on the opposite side of the contract.
This is exactly the opposite to the goals of the central bank. It would also create opportunities for large
market makers to hold short positions and diminish the control of the central bank over expectations of
market participants.
A short strangle trading strategy combines the short put option and short call option strategy. The
short strangle strategy can be a good one for the central bank if there are limited risks of drastic exchange
rate movements. The strategy allows the central bank to be the main market maker, exert control over
the currency options market, and ensure liquidity in both the spot and options market.
Despite the benefits of this strategy, there are a number of sizable drawbacks of pursuing such the
short strangle strategy for the central bank specifically. Issuing call and put options exposes the central
bank to unlimited downside risk with limited gains, as can be seen in Figure (5). Such a strategy would
need to be dynamically delta hedged to protect the central bank from losses associated with drastic
movement in the exchange rate. Hedging such a position through an offsetting spot market position
would force the central bank to contribute to the persistent appreciation or depreciation of the exchange
rate. The position of the central bank in the spot market to offset the risks of the short options counters
the goals of the central bank to ensure stable exchange rate values and limit the volatility in the market.
Authors such as Breuer (1999) have noted that dynamically delta hedging a long option contract
position can introduce stabilizing forces into currency markets. By dynamically delta hedging a long
call on USD, the trader will hold an offsetting short position in USD, for example. If the currency
(COPUSD) depreciates, the trader will sell USD in domestic spot market. By doing so, the supply of
USD in the spot market rises and therefore introduces appreciationary pressure that can counter the
depreciation of the COP through the portfolio balance channel. Similarly, by holding a long put position,
the offsetting spot market position would be long in USD. As the currency depreciates, the long put will
expire out of the money and not be exercised. The trader will sell USD (or buy COP) in spot market
to offset his position at maturity of the option contract. The offsetting spot market position contributes

20

Figure 5: Short Strangle Option Strategy

Short strangle presents an options trading position with unlimited risks and limited gains. The strike price for the short call and short put position equal at
K.

to a counteracting appreciation pressure on the depreciation of the COP.

Due to the limited risks associated with a long options position, few traders would have the incentives
to engage in dynamically delta hedging the position. Therefore, despite the fact that the hedging of a
long position may introduce a stabilizing force into the currency market, the central bank cannot rely
on market participants to act in such a way.
The optimal strategy for the central bank will be one that includes both long and short positions
in call and put options. Taking on both long and short positions in the option contract is considered a
butterfly spread trading strategy. It is a neutral strategy with limited gains and limited downside risks.
Call butterfly spreads consist of the trader holding two long and two short positions in the call option.
Put butterfly spreads consist of the trader holding two long and two short positions in the put option.
In each, the options with a high and low strike price are purchased, whereas two options in the middle
strike price are issued. The strike prices for the long position are K1 and K3 in Table (6). The strike
price (K2) for the short position is the midpoint price between the long strike prices.
The traditional butterfly strategy has some benefits and drawbacks to reaching the goals of the
central bank. Dynamic delta hedging of such a strategy is typically unnecessary, since holding a long
and short position in each contract already hedges the risks to the trader of any movement in value of
the underlying asset.
For the central bank to have a strategic position in the spot market that is determined by the
dynamic delta hedge, which increases information flow, domestic liquidity and which lowers costs of
intervention, the optimal portfolio position for the central bank will be an alternative to the butterfly
strategy. Specifically, the optimal strategy will be for the central bank to write or short one call or one

21

Figure 6: Call and Put Butterfly Spreads

Call and put butterfly spreads present a neutral position with limited risks and limited gains. The middle strike price for the short position is determined as
K1+K3
.
2

put option contract at one strike price, and buy or long two call options or two put options at strike
prices that are slightly out of the money.
The alternative strategy that is used to simulate the position of the central bank in the spot market
is a derivative of the butterfly strategy. The gains and losses will be limited, and the net position of the
central bank in the spot market will one similar to hedging a long position. The central bank will be
able to issue contracts in the domestic market, purchase long positions in the global market, and hedge
its portfolio in the domestic spot market.
The long positions of the alternative butterfly strategy will hedge the risks associated with the short
position. By dynamically delta hedging the net portfolio position with an offsetting position in the spot
market, the central bank will have a position in the spot market that will stabilize the movement of the
domestic currency, smooth volatility, and influence the expectations of traders in a favorable way so as
to contribute to the stabilization goals of policymakers.
By holding and issuing bundles of call and put options at varying strike prices, the central bank
signals to the market that it is taking two positions. It is betting on the exchange rate to appreciate or
depreciate, and therefore is protecting itself by nullifying the net impact when the exchange rate moves
in either direction. The signal to the central bank from the market will come from how many of each
option will be purchased by market participants. If traders anticipate the currency to depreciate, more
call options will be purchased to hedge against the movement in the exchange rate. Between the date
of issue and maturity of the contract, the central bank will hedge its net portfolio position in the spot
market, which will provide a stabilizing force in the market.

22

Analytical Approach

In the following section, we will address the analytical approach used to determine how options contacts
may be used by central banks for intervention into currency markets. First, we will present the GarmanKohlhagen option pricing model, the alternative butterfly strategy and dynamic delta hedging. Next,
we will address the simulation of exchange rate movements used for analysis, as well as the derivation of
option prices and hedging positions based on the simulated exchange rates. The main objective of the
research is to test whether an alternative butterfly strategy with dynamic delta hedging can be a viable
strategy for central bank currency market intervention. The goal is to understand whether dynamic
delta hedging under this scenario is stabilizing and whether this strategy can provide the central bank
with a low cost, targeted intervention plan.

6.1

Alternative Butterfly Strategy with Dynamic Delta Hedging

The Garman-Kohlhagen option pricing model is a derivative of the Black-Scholes option valuation model.
The valuation of call options can be defined by the following:

St
ln
+
r r +
K
r

=e
St
2

vcall

2
2

(1)

The valuation of a put option is defined as:


St
ln
+
r r +
K
r

= e
St
2

vput

2
2

(2)

where = T t, or time to maturity, is the standard normal distribution function, is the volatility
of the underlying asset, r and r are the domestic and foreign risk free interest rates, St is the spot rate,
and K is the strike price. In the analysis presented in this segment of research, the purchaser of the call
(put) option, or the agent that is long in the option, has the right but not the obligation to buy (sell)
one unit of foreign currency or USD. The issuer, which will be the central bank, has the obligation to
sell (buy) one USD to the call (put) holder upon maturity if the option is exercised. All options in this
research are European options, and therefore cannot be exercised until maturity.
Dynamic delta hedging allows the issuer of the option to take an offsetting position in the spot
market to cover their risk. The delta of the option is the responsiveness of the option value to changes
in the value of the underlying asset and is the basis for risk management using dynamic delta hedging.
The call and put deltas the derivative of the option value with respect to the spot exchange rate, and

23

can be presented as follows:

vcall = er (x + 2)
vput = er
where x =



2
S
ln Kt + rr + 2

(x + 2) 1

(3)
(4)

and 0 vcall 1 for call deltas and 1 vput 0 for put deltas.

For traders in the short option position, the trader would take a long position in the spot market
for the underlying asset by delta units. For small changes in the underlying, the value of the hedge
will change by an equal amount in the opposite direction. The trader incrementally adjusts his position
throughout the time to maturity. In reality, traders hedge their entire portfolios, not single options
contracts. Therefore, the trader takes into consideration their net position when determining the dynamic
hedge (Chen, 1998, DeRosa, 2011).
As discussed by a number of authors mentioned above, dynamic delta hedging of a short option
position by the central bank may create additional destabilization in currency markets. These approaches
consider only the scenario under which the central bank issues only calls or only put options, where in
fact the hedging position would exacerbate the movement in the exchange rate. By positioning itself in
the alternative butterfly strategy, the central bank can strategically hedge its net position in a way that
would counteract the persistent appreciation or depreciation of the currency.
If we consider an example where there has been persistent appreciation over the last 10, 20 or 30
days, the central bank can hold and issue a bundle of calls and puts. The put options will be exercised,
while the call options will expire out of the money. By hedging the net position, the central bank
would be buying USD in the spot market to hedge both the call and put option position. Through
the portfolio balance channel, it would therefore introduce depreciationary pressure to counteract the
persistent appreciation.
In contrast, if there is a persistent depreciation over the last 10, 20 or 30 days, the call options will be
exercised, while the put options will expire out of the money. By hedging the net portfolio position, the
central bank would be selling USD in the spot market for both the call and put option position. Through
the portfolio balance channel, it would therefore introduce appreciationary pressure to counteract the
persistent depreciation.
The stabilization effect of holding and issuing a tailored bundle of call and put options is twofold.
First, as discussed in Machnes (2006) and Sarwar (2003), the amount of calls and puts that are traded
will effect the movement of the exchange rate and future volatility. Specifically, Machnes finds that
trading of calls (puts) corresponds to greater depreciation (appreciation) pressure from one day to the
next. Secondly, the dynamic delta hedging of a tailored net position will contribute to a position in the

24

spot market that counters the persistent movement of the exchange rate.

6.2

Simulation of Options Strategy

To understand the potential for central banks to use options as a currency market intervention tool, we
approach the analysis in three steps. Based on data from Colombia for COPUSD spot rates, we first
simulate exchange rate movements using first a random process and then an Ornstein-Uhlenbeck process
with GARCH volatility. The second simulation allows for price volatility to remain non-constant and
ensure positive exchange rate values. Next, we use data from Colombia for the domestic interest rate,
an estimation for volatility, and US three month t-bill rates for the foreign interest rate to calculate call
and put prices and the corresponding deltas with the simulated exchange rate values. Lastly, using the
simulated time series, we calculate the dynamic delta hedging position, or spot market position during
the period when the option is issued to date of maturity, for the central bank when it issues only calls,
only puts, or a bundle of both calls and puts, or a alternative butterfly strategy.

6.2.1

Simulating Exchange Rates

Since Colombia has been intervening on a daily basis in its currency markets since 2010, to appropriately
analyze the potential for using an options-based intervention strategy without bias in the data, we
employ a simulated time series to calculate options prices and the dynamic delta hedging position for
the central bank. We simulate the exchange rate using first a random process with 90 repetitions and
then the Ornstein-Uhlenbeck process with GARCH volatility for 200 repetitions each with a time period
of 30 days.
In the random process simulation of exchange rates, we create two scenarios that represent persistent
appreciation and persistent depreciation of the COPUSD. We use a uniformly distributed psuedorandom
generation of exchange rates based on the value of COPUSD on October 20, 2012. This process controls
the simulation environment to test the option pricing and dynamic delta hedging position when the
exchange rate is moving strongly in one direction. It provides a clear picture of how the strategic
hedging behavior of the central bank may introduce stabilizing pressure into currency markets.
Simulating the exchange rate movement using an Ornstein-Uhlenbeck process with GARCH volatility
is an optimal approach because it allows for non-constant volatility while ensuring positive exchange
rate values. The Ornstein-Uhlenbeck process is a stochastic process that is stationary, Gaussian and
Markovian. Therefore, time shifts leave joint probabilities unchanged, the vector of values if multivariate
normally distributed, and the future is determined only by the present and not past values (Finch,
2004). The process is also mean-reverting and has been used to model interest rates, exchange rates and

25

commodity prices in financial mathematics.

The Ornstein-Uhlenbeck process must first satisfy the following linear stochastic difference equation:

dXt = (Xt )dt + dWt

(5)

where Wt is a Brownian motion so that t 0. In the asymptotically stationary case, , , are constants
which yield the following moments:
E(Xt | X0 ) = + (c )et

Cov(Xs , Xt ) =


2  |st|
e
e(s+t)
2

(6)

(7)

To follow a Brownian motion, = c = 0, = 1 and tends to zero. Here, the variance, is positive
and constant. To simulate exchange rate movements, it is preferable for the variance or volatility to be
non-constant. Therefore, to alter the process, is determined with a GARCH(1,1) process.
Modeling volatility based on GARCH(p,q) model is typical in the financial mathematics literature,
and is used extensively by professionals and academics alike. Modeling stochastic volatility using the
GARCH process assumes that the randomness of the variance process varies with the variance of the
model, allowing volatility to be non-constant. The standard GARCH(p,q) model is defined as:
2
2
+ ... + p tp
2 = 0 + 1 2t1 + ... + q 2tq + 1 t1

2 = 0 +

q
X

i 2ti +

i=1

p
X

2
i ti

(8)

i=1

The structure of the volatility model can be defined as

xt = t () + t

(9)

t = t ()zt

(10)

2 () = E (xt t ())2 | Ft1

(11)

where

where Ft1 is the information set available at time t, t () is the dynamics of the conditional mean set
by an ARMA(p,q) process, t is the residual term, and is the vector of unknown parameters (Jondeau,
Poon and Rockinger, 2007). Volatility in this model is an exact function of a set of given variables.
Specifically, for the process presented below the known variables used to calculate volatility are past

26

values of the COPUSD exchange rate.

After simulating 200 processes, we calculate the average difference in exchange rates over thirty days
for each process. Based on the average change in exchange rates over thirty days, we segment the
processes into two groups for additional analysis. The first group experienced on average a negative
change in exchange rates, or a period of appreciation of the COPUSD. The second group experienced
on average a positive change in exchange rates, or a period of depreciation of the COPUSD. The groups
will be referred to below as appreciation-periods and depreciation-periods to distinguish between the
prior movements of the exchange rate.
The reason for segmentation into two groups is to account for the appropriate distribution of calls
and puts issued in the alternative butterfly strategy bundle. During periods of appreciation, a putcall ratio below one would ensures the central banks dynamic delta hedging strategy will introduce
depreciationary pressure into the market through net purchase of USD over the period to maturity. In
addition, with more calls exercised at maturity, this will also contribute to counteracting the appreciation
(Machnes, 2006). During depreciationary periods, a put-call ratio greater than one will yield pressure
from the central bank that may counter the rise in COPUSD and introduce more stability into the
market. Segmenting the simulated processes into two groups makes this analysis much easier to conduct
and interpret.

6.2.2

Calculating Options Bundle and Dynamic Delta Hedging Position

To calculate the dynamic delta hedging position and option prices, we first start with deriving the
volatility that will be used for analysis. In this model, we use the standard deviation of the log difference
of the exchange rate over ten days.2 The next step is to determine the strike prices that will be used to
calculate the option prices. The set of strike prices in the results presented below are defined as follows,
where St represents the spot market exchange rate at time t:
Kt,1 = 0.9975 St
Kt,3 = 1.0025 St
Kt,2 =

Kt,1 +Kt,3
2

After the volatility and strike prices are determined, we determine the call and put prices, as well
as the deltas of each using the Colombia risk free interest rate, the US risk free interest rate, and the
simulated exchange rate series discussed above. The time to maturity for all contracts is 30 days.
To determine the dynamic delta hedging position of the central bank, we calculate for each option
the total shares purchased on a daily basis, the daily interest and cumulative costs, and the end of
2

Volatility measured over a 5, 10 and 20 day period were estimated with little difference in analysis.

27

period cumulative costs, payoffs and profits. The daily total shares purchased are the daily option delta
multiplied by the option contract size, which is assumed to be USD$ 10,000.
The cumulative costs at t = 1 are the total shares of USD purchased in the domestic currency or
SharesU SD,t . For t > 1, cumulative costs are calculated as:
CostCum,t = CostCum,t1 + CostInt,t1 + SharesU SD,t
The interest costs are determined as:
 (t+1) t

CostInt,t = er 365 365 1 CostCum,t
The end of period cumulative cost for the long position is calculated as:
CostCum,T = CostCum,t=T + T ST
The end of period cumulative cost for the short position is calculated as:
CostCum,T = CostCum,t=T T ST
where is the number of shares per contract, or US$ 10,000. The end of period payoff for call options
is:
P ayof fcalls = max(ST K, 0)
and for put options:
P ayof fputs = max(K ST , 0)
For the long position, the net gains are equal to the payoff at the end of the period, and the net losses are
equal to the cumulative delta hedging costs over the 30 days plus the premium paid for the contract. For
the short position, the net gains are equal to the premium, and the net losses are equal to the cumulative
delta hedging costs over the 30 days plus the payoffs. Table (6) presents a summary of calculations.
Theoretically, the profit or loss for the issuer when dynamically delta hedging should be zero.

Currency Options as a Central Bank Intervention Tool

The goals of research are to analyze whether the net dynamic delta hedging position for an alternative
butterfly strategy for a bundle of call and put options is smaller than holding a one-sided position, to
understand if such a hedging strategy may introduce pressure into the market to counteract the current
movement of the exchange rate and to determine whether the costs to issue such a portfolio position
while hedging are lower than the costs of daily currency market interventions. It is assumed that one
contract is for $ 10,000 USD, and that the central bank issues a total of 10,000 contracts at one time.

28

Table 6: Summary of Dynamic Delta Hedging Cost Calculations

Cumulative Hedging Costs

End of Period (T = 30)

Long Call Position
Short Call Position
Long Put Position
Short Put Position
CostCum,t=T +T ST CostCum,t=T T ST CostCum,t=T +T ST CostCum,t=T T ST

Payoff

max(ST K, 0)

max(ST K, 0)

max(K ST , 0)

max(K ST , 0)

Premium

CallP rice

CallP rice

P utP rice

P utP rice

Net Gains

Payoff

Premium

Payoff

Premium

Net Losses

Hedge Costs + Pre- Hedge Costs + Payoff

mium

Hedge Costs + Pre- Hedge Costs + Payoff

mium

Cost calculations to the central bank to dynamically delta hedge its net portfolio position over an option contract period of 30 days. ST
represents the spot exchange rate at maturity, or t = T . represents the contract size which is US$ 10,000. CostCum,t=T represents the
cumulative dynamic delta hedging cost on the last day of the contract or t = T . T is the delta of the option contract at t = T where T = 30.

To understand the potential for using currency options as a central bank tool for intervention into
foreign exchange markets, we start first with the simulated exchange rates for COPUSD over 90 repetitions under scenarios with persistent appreciation and persistent depreciation. Figure (7) illustrates the
simulation. Using these simulations introduces a controlled environment under which we can first test
the alternative butterfly strategy with dynamic delta hedging.

Figure 7: Series of Simulated Exchange Rates

Exchange rates are simulated as a random distribution to represent periods of appreciation and depreciation. The start value of simulation is based on 10
day average COPUSD exchange rates ending in October 20, 2012.

Figures (8) and (9) calculate the dynamic delta hedging position and daily cumulative costs of hedging
during a period of depreciation. The daily shares purchased represent the actual amount of USD the
central bank is buying or selling in the spot market based on the net portfolio position and is determined

29

by the deltas of each option contract in the portfolio. The cumulative daily hedging costs include the
interest costs and costs of purchasing shares of the foreign currency in the spot market.
There are three scenarios depicted in each figure. The first is a call butterfly strategy, where the
central bank is holding (long) and issuing (short) only call options. The initial spot market position is
substantial, requiring the central bank to sell approximately $ 60 million USD in the spot market in
one day. Throughout the period to maturity, the net portfolio position will require the central bank to
continue selling USD in the spot market to dynamically delta hedge its options portfolio. By doing so,
it will in turn introduce a counteracting pressure to the persistent depreciation. Under a put butterfly
position, the central bank initially conducts large purchase of USD in the spot market and subsequently
sells off its initial spot market position throughout the period to maturity.
The net dynamic delta hedging position of both strategies allows the central bank to have a smaller
initial position in the spot market, but it continues to sell USD over the period to maturity. Through
dynamically delta hedging its net portfolio position, the central bank has a clear strategic approach to
its spot market position, one that also introduces a stabilizing force into currency markets through the
portfolio balance channel. Altering the put-call ratio to represent more call options, as seen in Figure
(9), strengthens the position of the central bank on the initial day of the contract, but does not change
the spot market position throughout the period to maturity.
Figures (10) and (11) calculate the dynamic delta hedging position and daily cumulative costs of
hedging during a period of appreciation. Once again, three scenarios are presented in each figure.
The first call butterfly strategy, shows initial spot market position that requires the central bank to
sell approximately $ 60 million USD in one day. This can be potentially destabilizing to the market.
Throughout the period to maturity, the net portfolio position will require the central bank to buy USD
in the spot market to dynamically delta hedge its position. The daily purchases of USD may in turn
introduce a counteracting pressure to the persistent appreciation through the portfolio balance channel
by driving up the value of USD relative to the domestic currency.
In the put butterfly position, the central bank initially conducts large purchase of USD in the spot
market and continues purchasing USD throughout the period to maturity. The net position of both
strategies allows the central bank to continue to sell USD over the period to maturity. Altering the
put-call ratio to represent more call options, as seen in Figure (11), forces the central bank to sell USD
in the spot market on the initial day of the contract, but to continue purchasing USD throughout the
period to maturity.
The total cumulative costs represent the end of contract period costs of dynamic delta hedging
that accumulated from daily hedging. The outstanding position of the central bank from its hedging

30

Figure 8: Depreciation Dynamic Delta Hedging Outcomes - Put/Call: 1

The dynamic delta hedging position is calculated for 90 series of 31 days. The exchange rate is steadily depreciating over the period to maturity. The put/call
ratio is 1. As can be seen, holding a position in both a call and put strategy is the least disruptive to the spot market.

31

Figure 9: Depreciation Dynamic Delta Hedging Outcomes - Put/Call: 0.25

The dynamic delta hedging position is calculated for 90 series of 31 days. The exchange rate is steadily depreciating over the period to maturity. The put/call
ratio is 0.25. As can be seen, holding a position in both a call and put strategy is the least disruptive to the spot market.

32

Figure 10: Appreciation Dynamic Delta Hedging Outcomes - Put/Call: 1

The dynamic delta hedging position is calculated for 90 series of 31 days. The exchange rate is steadily appreciating over the period to maturity. The put/call
ratio is 1. As can be seen, holding a position in both a call and put strategy is the least disruptive to the spot market.

33

Figure 11: Appreciation Dynamic Delta Hedging Outcomes - Put/Call: 4

The dynamic delta hedging position is calculated for 90 series of 31 days. The exchange rate is steadily appreciating over the period to maturity. The put/call
ratio is 4. As can be seen, holding a position in both a call and put strategy is the least disruptive to the spot market.

34

operations and its options contracts will be determined by the hedging costs, payoffs and premiums,
presented in Table (7). If the central bank holds and issues the equivalence of US$ 100 million in option
contracts through the alternative butterfly strategy, its costs to dynamically delta hedge the position
will accumulate to less than US$ 1 million. Compared to the costs in terms of reserve accumulation
to buy and sell USD on the spot market daily, as Colombia has done, these costs are very small. The
net costs of the overall portfolio position are even smaller. Therefore, in terms of costs of intervention,
clearly the options-based strategy is better than daily discretionary interventions.

Table 7: End of Period Dynamic Delta Costs, Payoffs and Premiums

Delta Hedging Costs

Call Payoff
Put Payoff
Premium
Net Costs (Calls)
Net Costs (Puts)
Net Costs (All)

Average Across Series (USD)

Appreciation
642,100
0
1,858,300
337,770
-48,215
-56,404
-52,310

Depreciation
851,290
2,335,900
0
323,850
-19,059
-27,068
-23,064

Total cumulative costs represent the end of contract period cumulative costs of dynamic delta hedging that accumulated
from daily hedging. Total dynamic delta hedging costs represent the end of period cumulative costs and payoffs if the
contract was exercised. Each contract size in US$ 10,000, and there were 10,000 contracts issued.

Next we use the Ornstein-Uhlenbeck process with GARCH volatility to simulate the COPUSD exchange rate over thirty days. In addition to all 200 scenarios, we also use the first three series to analyze
a short sample of the data. The simulated values of exchange rates for each of the three series is also
captured in Figure (12). As seen in the figure, there are some drastic outliers that will drive extreme
hedging positions for the central bank. We want to consider all scenarios that the central bank may
face.
In Figure (13), the dynamic delta hedging position of the central bank is depicted in terms of the
total daily shares of USD purchased in the spot market and the daily hedging costs. Here, the dynamic
delta hedging position is shown for all 200 simulations of the COPUSD. Once again, the initial position
in the spot market at the start of the contract is smaller when the central bank is holding a net position
in both calls and puts. The cumulative daily hedging costs are limited as well, with an upper bound of
$ 40 million USD per day, and lower bound of $ 45 million USD per day, which is comparable to the
daily discretionary purchases of the Colombian central bank in 2012.
In Figure (14), the simulated series are segmented into two groups, one where the COPUSD is on
average appreciating and one where the COPUSD is on average depreciating over the period to maturity.
The differences in the daily shares purchased if the central bank holds only calls, only puts, or both is
limited to the initial spot market position at the beginning of the contract. Otherwise, the currency

35

Figure 12: OH-GARCH Simulated Exchange Rates

Exchange rates are simulated with a GARCH volatility process with an Ornstein-Uhlenbeck process to keep price volatility non-constant but exchange rates
positive. The start value of simulation is based on 10 day average COPUSD exchange rates ending in October 20, 2012.

Figure 13: OH-GARCH Series Dynamic Delta Hedging Outcomes

The dynamic delta hedging position is calculated for 200 series of 31 days. The series include periods of both appreciation and depreciation. The put/call
ratio is 1.

36

market pressures exerted through the central banks strategic trading in the spot market is consistent
across all three strategies.

Figure 14: OH-GARCH Series Dynamic Delta Hedging Outcomes - Shares Purchased

The dynamic delta hedging position is calculated for 200 series of 31 days and then segmented into series include periods of appreciation and depreciation.
The put/call ratio is 1.

To breakdown the analysis of the 200 simulations and present a clear picture of the hedging position of the
central bank using the simulated exchange rates, Figure (15) depicts the hedging position using the three scenarios
presented in Figure (12). Because each series has a non-constant volatility, the daily shares of USD purchased in
the spot market varies depending on whether the COPUSD is appreciating or depreciating. From Figures (8) to
(11), we know that the dynamic delta hedging position of the central bank will be one that will introduce

counterbalancing pressure on the exchange rate. Once again, the daily hedging costs are lower when the
central bank holds positions in both calls and puts.
The end of period cumulative hedging costs, payoffs and premiums are depicted for the three series in
each group as well as for all 200 simulations in Table (8). Each contract size is US$ 10,000 with 10,000
contracts issued. Across all groups, it is evident that the costs to the central bank for issuing bundles of
calls and puts while dynamically delta hedging the position is much lower than a daily intervention of US$
20 million. The central bank will be able to hold a strategically determined position in the spot market
that is driven by the responsiveness of the option price to the underlying asset value that is of comparable
37

Figure 15: OH-GARCH Series Dynamic Delta Hedging Outcomes - Short Sample

The dynamic delta hedging position is calculated for 3 series of 31 days. The series include periods of both appreciation and depreciation. The put/call ratio
is 1.

38

size to the current strategy of daily discretionary interventions. The difference is that the option strategy
comes at a lower cost in terms of reserve accumulation, and the spot market position of the central bank
is determined and changed depending on market dynamics.
Table 8: OH-GARCH End of Period Dynamic Delta Costs, Payoffs and Premiums

Delta Hedging Costs

Call Payoff
Put Payoff
Premium
Net Costs (Calls)
Net Costs (Puts)
Net Costs (All)

Delta Hedging Costs

Call Payoff
Put Payoff
Premium
Net Costs (Calls)
Net Costs (Puts)
Net Costs (All)

Average Across Series (USD)

Series (200)
Appreciation
-409,150
-402,900
281,990
19,185
308,800
586,820
331,720
333,510
389,311
395,580
381,202
387,450
385,257
391,515
Short Sample
Series (1)
-16,590
1,794,100
0
1,991,200
555,380
547,390
551,390

Series (2)
-227,150
0
342,000
1,989,000
50,290
42,140
46,210

Depreciation
-415,790
557,710
13,506
329,820
382,660
374,570
378,615

Series (3)
-296,920
0
454,000
1,998,800
174,340
166,210
170,280

Total cumulative costs represent the end of contract period cumulative costs of dynamic delta hedging that accumulated from daily hedging. Total
dynamic delta hedging costs represent the end of period cumulative costs and payoffs if the contract was exercised. Each contract size in US$
10,000, and there were 10,000 contracts issued.

Implications

Many central bankers in emerging markets and developing economies are concerned with the movement of
the countrys exchange rate and have attempted to influence expectations, smooth volatility, and control
the direction of the exchange rate through spot market interventions using foreign exchange reserves. Such
interventions tend to be costly in terms of reserve accumulation and sterilization, with an unclear strategic
approach to the purchase and sale of foreign currency in the domestic spot market.
Colombia has tried various strategies of intervention, including issuing options to accumulate foreign
exchange reserves and to smooth volatility, as well as relying on daily spot market interventions. The
use of volatility options in the past has been unsuccessful mainly due to the sporadic issuance and onesided approach. When currency options are held and issued on a consistent basis using a mix of call
and put options at various strike prices, the strategy can increase liquidity, build markets and financial
development, and increase the flow of information between market participants and policy makers. Dynamic
delta hedging of the net position also provides the central bank with a strategic approach for its position
in the spot market and the ability to influence expectations and future movement of the exchange rate at
a lower cost than daily interventions.
39

The abandonment of options contracts as a tool for central bank intervention into currency markets
was premature. The case of Colombia shows that taking only one side of the market yields inconclusive
results on influencing volatility and market expectations, whereas daily intervention into spot markets is
costly in terms of reserve accumulation and sterilization problems. The research presented in this paper
shows that by holding and issuing tailored bundles of call and put options while dynamically delta hedging
the position allows the central bank to intervene in currency markets at a lower cost than daily purchases
of USD, while holding a net position in the spot market that is less disruptive than hedging only one side
of the market.
There are a number of extensions for future research that will be done based on the findings presented in
this chapter. One of the limitation of the research presented here is the lack of analysis of volatility. Future
research will analyze the impact of various intervention strategies on exchange rate volatility, including
options-based strategy and pure market intervention.
Since many emerging markets have now adopted inflation targeting are part of their policy decisions,
the Garman-Kohlhagen model can be extended to include a Taylor-rule inflation targeting goal to analyze
the results of an options-based intervention strategy. Research conducted by Arizmendi (2013) illustrates
how an inflation targeting rule can be incorporated into the options pricing model so that policy choice for
intervention can be directly linked to inflation targeting goals.
In addition to the alternative butterfly strategy presented in the paper, the long iron condor may be
another strategy that can be adopted by central banks. The long iron condor requires a short position in
both calls and puts that are slightly out-of-the-money while also holding a long position in both calls and
puts that are further out-of-the-money. This is a neutral position with limited profits and downside risks.
For central banks averse to dynamic delta hedging in the spot market, or for those that would continue
with daily interventions, the long iron condor is an alternative strategy to consider.
The topic of currency market intervention to smooth volatility and protect the economy from external
shocks is a topic that is very relevant given the current global dynamics. With the Federal Reserves
tapering of its quantitative easing strategy, as well as the slowing of growth in China, there are massive
changes in foreign currency flows that are leaving emerging markets and developing economies susceptible
to drastic exchange rate fluctuations. Many will deplete their foreign reserves trying to smooth out the
volatility and protect the domestic currency from plummeting. Considering alternatives to spot market
intervention is imperative in todays global economy. The research presented in this chapter contributes
to revisiting the discussion of alternative tools that can be effective and less costly in maintain stability
and calm in disorderly currency markets.

40

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