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| Information Content of Foreign Exchange Options and the Efficiency of the Onshore/Offshore Markets |
| ZHENG Zhenlong, HUANG Shanshan, GUO Boyang
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School of Management, Xiamen University;
School of Economics, Xiamen University;
Derivatives Trading Department, China Merchants Securities Co., Ltd. |
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Abstract The People’s Bank of China has been using a more market-oriented method to determine the CNY central parity rate since August 11, 2015. However, the effect of this method on the RMB derivative markets remains unknown. Among the RMB FX derivatives, the onshore CNY options and offshore non-deliverable CNY options share the same underlying asset: the onshore CNY exchange rate. However, there are always differences in the prices of these two options due to the regulations that limit onshore-offshore arbitrage, which results in different option-implied FX distributions and information in the two markets.
To compare the market efficiency of the onshore and offshore option markets, we use the data on the onshore USD/CNY options and offshore non-deliverable USD/CNY options with one month maturities. The information implied in these options is comparable because they share the same underlying asset, the onshore USD/CNY exchange rate. Specifically, we divide our sample into three periods: before the FX reform, the brief period after the FX reform, and the later period after the FX reform. Following studies such as Jiang and Tian (2005) and Bakshi et al. (2003), we extract the model-free implied volatility and risk-neutral skewness from both the onshore and offshore one-month USD/CNY options. Based on the information extracted from the bid-ask Black-Scholes implied volatility price data of the USD/CNY options portfolio, we test the predictability of the implied volatility and risk-neutral skewness on the yield, volatility, and tail risk of the future exchange rates in the three subsamples. We also compare the information in the two markets and the variations in different periods to determine whether the FX reform improved the information content in both markets. We then empirically collect the closing prices of the onshore and offshore USD/CNY options, the closing spot prices, and the forward USD/CNY exchange rates from Bloomberg.
With respect to risk-neutral skewness, our results show that before the FX reform, the onshore risk-neutral skewness only covers the tail risk information and it has weak predictability on the variation in the future exchange rates. During the short period after the FX reform, the offshore risk-neutral skewness completely covers the information in its onshore counterpart. The information efficiency of the offshore market is also significantly better than that of the onshore market. In the later period after the FX reform, the risk-neutral skewness in both markets covers the information on the variation in the future exchange rates. In this case, the information efficiency of the onshore market is slightly better than that of the offshore market.
With respect to the implied volatility, the results show that before the FX reform, the implied volatility has weak predictability on the future volatility in both markets. During the brief period after the FX reform, the onshore implied volatility significantly predicts the future volatility of the USD/CNY exchange rate. However, the offshore implied volatility does not cover the information on the future volatility. In the later period after the FX reform, the implied volatility in both markets covers the information on the future volatility. Moreover, the offshore implied volatility covers all of the information about its onshore counterpart and the historical volatility. Thus, the offshore market is significantly information efficient.
In the two subsamples after the FX reform, we obtain different results when we test the information efficiency separately in terms of the implied volatility and risk-neutral skewness. However, when we conduct the full analysis, after the FX reform, as the central parity rate becomes more market-oriented, the FX option prices cover more and more information on the future exchange rate distribution. The information efficiency of both the onshore and offshore option markets also notably increases. These results indicate that the market-oriented mechanism of the CNY central parity rate can enhance the efficiency of the Chinese financial market. Therefore, in terms of balancing the financial security, steadily promoting the market-oriented mechanism of the CNY central parity rate will help improve the efficiency of the Chinese financial market.
Our findings have strong implications in regard to whether further exchange rate reforms should be implemented and how they should be promoted. However, the question remains as to why the implied volatility and risk neutral skewness produce different results and whether other factors affect the information efficiency of the two markets. These issues warrant further research attention.
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Received: 26 September 2017
Published: 24 October 2019
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