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

2. 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

3. 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)

4. 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/ 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

5. 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%

6. 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)

7. Comparing the 3 markets: All data

8. Comparing the 3 markets: Similar data

11. 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

13. 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

14. 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

15. 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%

16. 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

17. Forecasting capability (next quarter volatility by IV)

18. 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

19. 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

20. The End