Efficiency of the Currency Options Market During The Global Financial Crisis

Abstract

Credit derivative mispricing is one of the fundamental causes of the recent Global Financial Crisis (GFC). Heavy speculation of Credit Default Swaps (CDS), unregulated over-thecounter (OTC) derivatives and unsupervised nonbank derivativesdealer activities are the key issues for credit derivativemispricing. Currency option derivatives have been used as a popular speculation and hedging tool for the last three decades. Since all kind of derivatives are analogous in the context of managing financial risk, we are also concerned about the pricing of the major currency options during the GFC. This study therefore examines the efficiency of the currency options market from 1 January 2008 to 31 December 2011 and 1 January 2012 to 31 January 2012, covering the GFC and post-GFC periods, respectively. The options on the Australian dollar (AUD), the British pound (BP), the Canadian dollar (CAD), the Euro (EUR), the Japanese yen (JPY) and the Swiss franc (SF) are used as samples in this study. We found that the currency options market was inefficient in the GFC period, leading to the major currency options being mispriced. However, these currency options were priced accurately after the GFC period. The implication of the results is that currency options would not be appropriate to manage foreign exchange (FX) exposure when the market is experiencing a poor or crisis period. The findings of this study are therefore alarming for FX market participants.