Central Bank’s Foreign Exchange Market Intervention by a Variety of Options

This paper studies the possibility of options as an instrument for central bank to intervene foreign exchange market. As opposed to spot trade or forward trade, which impacts spot rate only once, options can continuously resist a directional speculative pressure on spot market due to the dynamic delta hedging of options market maker. In order to investigate the feedback relationship between spot market and options market, a dynamical model is built. It is demonstrated that an adequate configuration and a proper position of plain vanilla option can achieve a sort of robustness and resilience in harsh environments. More importantly, a certain barrier option position can not only possess similar robustness to plain vanilla options but also have a greater effectiveness, which is defined as the size of the eventual change of spot rate per the same notional amount, than direct spot market intervention. Finally, the recommendations on the position and the kinds of options are made.