The Emerging Market Economies are vulnerable to adverse external shocks. Such shocks cause excessive volatility in foreign exchange markets. Faced with high volatility, the central banks in EMEs often end up, in futility, depleting their foreign exchange reserves by selling dollars to restore stability. Few central banks use currency-options based intervention to contain volatility and anchor market expectations. In the Indian context, this paper demonstrates that such options-based intervention policies can be considered to contain excessive volatility and anchoring market expectations. Using the risk-neutral densities extracted from currency options data, it is demonstrated that certain options-trading strategy can be effective in stabilizing markets. Therefore, options-based intervention may be a viable policy alternative, which is more cost-effective than the conventional spot-market intervention.
Fx interventions risk-neutral density currency options