The Foreign Exchange Option Markets in a Small Open Economy Menachem Brenner and Ben Schreiber Research Dept., BOI October 2006

Objectives: Exploring the efficiency of three related foreign exchange option markets The markets: Bank of Israel - BOI, Over The Counter - OTC, and Tel-Aviv Stock Exchange - TASE Examining the information content imbedded in options traded in these markets Assessing the impact of liquidity on the pricing of options (implied volatilities) and vice versa in the various markets

Review of the literature: The importance of FX option markets in small open economies Implied volatility as a predictor of future FX volatility (Jorion 1995, Szakmary et al., 2003) Volatility risk premium (Low and Zhang, 2005) and the “smile effect” in FX (Carr and Wu, 2004) The impact of illiquidity (Amihud and Mendelson, 1986; Brenner, Eldor, and Hauser, 2001; Chan, Hong, and Subrahmanayam, 2006; Eldor et al., 2006)

Description of markets and data: Three FX option markets active simultaneously Market main characteristics: OTC (many instruments, large notional values, tailored) TASE (options only, large volumes, short horizons) BOI (ILS/USD ATMF options only, small volumes, 3/6 months to expiration, auctions twice a week) Reports to the Bank of Israel cover all transactions in the Israel’s option markets during the period: 10/2001–12/2004 Our database, excluding outliers, consists of : 34,529 OTC transactions, 21,182 TASE transactions, and 315 BOI ones

Description of data – No filtering : MAX MIN Mean OTC 1,209 1 79 Days to maturity 16% -19.4% -0.9% Moneyness 24.8% 1.2% 7.9% Implied volatility TASE 371 2 42 16.1% -16.7% -0.3% 32.5% 1.3% 9.1% BOI 93 89 90 0% 11.6% 3.7% 6.7%

Comparing the 3 markets: Q1: Are the IVs in all markets the same? Q2: If not, what are the factors that explain the differences? Q3: is there room for arbitrage? H0: IV(BOI) = IV(TASE) ; IV(BOI) = IV(OTC) ; IV(TASE) = IV(OTC) The null hypothesis is tested by two methods: 1. Comparing IVs computed from similar options (days to expiration and moneyness) 2. Comparing option prices using the methodology outlined in BEH (2001)

Comparing the 3 markets: All data

Comparing the 3 markets: Similar data

Comparing the 3 markets: By equality tests of the mean, median, and variance one can reject the null that the markets are similar for all data However, for similar data (day to expiration and moneyness) we cannot reject the null Is arbitrage possible? Using BEH’s method to estimating liquidity premiums (similar daily data, no transaction costs): Max Min Mean # days 36% -26% -2.9% 306 BOI Vs. OTC 30% -28% -2.5% BOI Vs. TASE 46% -37% 1.4% 551 TASE Vs. OTC

Bid-Ask Spreads All data OTMF ATMF ITMF OTC 9.5% 11.2% 13.2% 14.4% Mean 0.1% 0% Min 41.6% 73.3% 57.4% 87.1% Max All data OTMF ATMF ITMF TASE 17.5% 13.9% 18.1% 20.2% Mean 4.2% 3.2% 3.1% 2.2% Min 63.7% 55.7% 133.1% 75.2% Max

Relationships between markets around TASE’s expiration day (As percentage of TASE expiration day's data) BOI Volume #Transact. OTC TASE Volume #Transact. Day of the month 39 38 66 63 95 72 Max 11 15 18 17 24 16 Min 27 42 41 69 36 Average 94 86 93 92 100 58 Day after expiration 98 96 61 124 97 Day before expiration Expiration day

TSLS Regression results: IV and B-A Spreads TASE- Coefficient OTC-Coefficient Endog. : D B-A Spreads 3.8** 2.9* D Implied volatility -0.1 -2.3** Log(Notional Value) 0.07 0.0 D Days to expiration -1.82* -2.6** D Moneyness 0.41 0.45 Adj. R2 Endog.: DImplied volatility 0.03** 0.01 D B-A Spreads 0.1 0.12* -0.01** 0.36** -0.15* 0.32 0.14 ** - Significance level of 1%, * - Significance level of 5%

Depth and efficiency measures (Basis points, mean daily data) All data OTMF ATMF ITMF OTC 6 15 58 64 Market depth -30 Skewness in IV -3 -10 3 Put-call deviation All data OTMF ATMF ITMF TASE 3 2 25 Market depth -5 Skewness in IV -1 -2 Put-call deviation

Forecasting capability (next quarter volatility by IV)

Forecasting capability – Cont’ OTC (ALL) OTC (ATMF) BOI TASE (ALL) TASE (ATMF) -1.2% -0.8% -0.7% -1.3% -1.1% Mean of Errors 2.8% 2.0% 1.9% 3.3% 2.7% RMSE 0.79 0.80 0.78 Correlation coef. Error = realized future volatility – current IV RMSE – Root Mean Squared Error

Conclusions: The three FX option markets are different in their main characteristics We cannot reject the hypothesis of similarity among markets once we control for moneyness and time to expiration Arbitrage is possible only for far OTMF short run options where volumes are small and B-A spreads are wide B-A spreads in TASE are wider than in OTC perhaps due to the dominant position of local banks (market makers) In contrast, market depth and efficiency measures are better in TASE than in OTC IV derived from ATMF OTC or BOI options are the best forecasters although all forecasts have over-estimated the realized future volatility

The End