Currency options: Hedging and social value

Abstract

In early September 1982 a conference on Exchange Rate Determination organized by L. Klein and W. Krelle took place at the Deutsche Bundesbank in Frankfurt. At this conference I presented a paper ‘Currency Options: Theory and Practicability’. This paper gave formulas for the pricing and hedging of currency options and showed, by means of ex-post simulations, their practicability. Examples were given of how to hedge $/DM options on either the spot, bond or forward market [cp. Sondermann (1985a)]. At that time markets for currency options did not yet exist.’ But I was convinced that these markets would soon emerge, since (i) the theory for pricing and hedging of currency options was now available, (ii) the computational facilities were available and, most importantly, (iii) currency options do have a social value. The stormy development of these markets which started soon after has proved this expectation correct. That currency options have a social value has been questioned both on practical and theoretical grounds. The first type of arguments stress the speculative element of such options and refer to the forward exchange markets as the approved means of hedging against foreign exchange risks. This view overlooks the fact that only future currency streams which are expected with certainty can be hedged on forward markets. If for some reason these future payments fail to realize or deviate from their expected value the ‘hedger’ on the forward market may end up with a costly open position. This may, e.g., be the case in a tender situation.* Currency options as a non-redundant alternative to forward markets allow for a better allocation of exchange risks. The social value of currency options is