Currency Options and Exchange Rate Economics

Posted by Allison on 13 April 2009, 10:57

The broader area of overall economics related to currency options and exchange rates is a big subject to tackle, but one that Currency Options and Exchange Rate Economics handles with ease.  It takes a slightly different approach than many other books about the foreign currency exchange market, combining the knowledge garnered by the academic world with the knowledge garnered by the real world of active foreign currency exchange traders. 

These two perspectives do not often come together in the same place, making Currency Options and Exchange Rate Economics both unique and significant.  The depth of information presented is substantial, providing the reader with an opportunity to dramatically increase their understanding and appreciation for the foreign currency exchange trading markets.

Using information for academic and practical purposes

Currency Options and Exchange Rate Economics sets the stage by describing the importance of combining academic and practical approaches so that the results benefit each other.  From the academic standpoint, it maintains, the wealth of data and information available on the behaviour of the currency markets has not been sufficiently evaluated and researched.  From the practical standpoint of foreign currency traders, on the other hand, such evaluation and research could offer some very important theories and models for understanding and predicting the behaviour of exchange rates.

The overall goal of the book is to help bring about the following:

  • Bring financial analysts closer to having a model of option pricing that is precise
  • Offer financial analysts a theory of macroeconomics that will help them better anticipate future behaviour of exchange rates and derivatives
  • Help governments and other monetary institutions be more effective with their policies by better understanding the behaviour patterns of the currency option market

This are very big goals, to be certain, and Currency Options and Exchange Rate Economics takes a very good shot at achieving them.  You can see, then, why this book has the potential to be an exceptional tool for many foreign currency exchange market traders.  Some might say this is a task that is too large for any single author to successfully handle, and perhaps it is.  However, this book and its unique approach to the subject help take it a long way toward achieving success in what it sets out to do.

Combining new content and existing research

One of the ways Currency Options and Exchange Rate Economics attempts to achieve the goals as listed above is by combining new content with existing research that is recognized and accepted as valid.  It is an insightful approach that could be quite intimidating if not handled well, but that is not a problem with this book.  The information is detailed and in depth, but presented in a way that is logical and structured.

Zhaohui Chen, the editor of the book, has gathered together a wealth of solid contributions from some of the highest calibre experts in foreign currency exchange trading.  These contributors include:

  • Jose' Manuel Campa – New York University
  • Charles A.E. Goodhart – London School of Economics
  • Louis O. Scott – University of Georgia
  • P.H. Kevin Chang – University of Southern California
  • Peter G. Zhang – Chase Manhattan Bank
  • Richard K. Lyons – University of California at Berkeley
  • Allan M. Malz – Federal Reserve Bank of New York

It should be noted that the most current edition of Currency Options and Exchange Rate Economics was published in 1999, so the contributors above are listed with their respective employment associations as of that publishing date.

Two sections for reading ease

To make the book easier to understand, it is divided into two main sections of emphasis.  The first section is introductory, containing the basics and foundations of both the real world currency option marketplace as well as the theories related to option pricing and activity.  The second section delves into the real “meat” of the subject, offering practical examples and applications for how commonly understood empirical and theoretical approaches to exchange rates are used to handle common problems and challenges in the exchange rate system.

Some of the topics in the first section are as follows:

  • The fundamentals and foundations of theories on option pricing, including the Black-Scholes model and the relationship of risk-neutral valuation
  • Understanding equity options with dividend
  • Understanding foreign currency options
  • The role of futures options
  • Use and definitions of traditional and contemporary Greeks in the foreign currency trading market
  • Vital factors and aspects of volatility and implied volatility
  • Key institutions involved in the foreign currency exchange trading markets
  • Characteristics and differences between over the counter markets and centralised exchanges
  • Standards and conventions of price quoting in the over the counter markets
  • Topics related to volatility, including risk reversals, straddles, and strangles
  • Terms and definitions related to the foreign currency exchange trading markets

All of the basics are covered in the first section, providing valuable background information for readers of all experience levels.

Some of the topics in the second section are as follows:

  • Overview and description of implied volatility
  • Models of option pricing related to implied volatility
  • Overview of empirical research findings about functions related to currency options
  • Overview of empirical research findings about functions related to stock options
  • Suggestions for topics and areas to be considered for continuing research
  • Understanding implied volatility and its term structure
  • Examples and explanations of key descriptive statistics and data statistics
  • Hypothesis testing of expectations
  • Understanding the theory of risk premium
  • Hypothesis testing of simple efficiency
  • Overview and evaluation of using a model of portfolio balance for risk premium
  • Understanding data used and the option model
  • Developing distribution probabilities for future exchange rates
  • Developing distribution probabilities for future option prices

These and other topics are discussed in excellent detail, providing very thorough explanation and posing interesting questions for the reader and others interested in foreign currency exchange trading to consider moving into the future.

Overall evaluation of the book

Overall, this is a very extensive and well constructed book.  The editor has brought together some of the best minds in foreign currency exchange market trading to examine this market from both an academic and a practical perspective.  It is thought provoking and very detailed, offering readers a tremendous amount of material to read, digest, and understand.

With this in mind, it should not be too surprising to suggest that Currency Options and Exchange Rate Economics is not a book that is well suited for the novice foreign currency trader.  Except for the first section where the basics and foundations of the market are discussed, the content is quite advanced and requires at least an intermediate to high level of knowledge about foreign currency exchange trading.

For instance, one of the chapters contains an extensive discussion of probabilities of ERM realignment using estimates based on option pricing.  This is an advanced topic area, bringing in a broad array of macroeconomic factors to influence the discussion.  Other chapters are equally detailed about some higher level subjects.

For the novice trader, this is quite and advanced book; they would likely be better served by a resource that focuses more on the specifics and “how to” information of foreign currency exchange trading.  For the intermediate to advanced trader, however, this book is an excellent resource for expanding knowledge and understanding of complex issues related to the foreign currency exchange markets.

Final thoughts

The combination of new content and widely accepted academic research contained in this book make it unique and of great value to a wide range of foreign currency exchange traders.  While it is not necessarily the first book a novice trader should add to their resource library, it is certainly a resource all intermediate and advanced traders should obtain and use as an informational tool.

Direct link to this book at Amazon

 

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