chapter 3 developments in the nis-forex derivatives markets · 2012. 7. 8. · 121 chapter 3...

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Chapter 3Developments in the NIS-Forex Derivatives MarketsThe NIS–forex derivatives market is comprised of options, forward contracts, and

swaps. Trading in this market takes place on three tracks:

* the nontradable over-the-counter (OTC) track;1

* the tradable track, on the Tel Aviv Stock Exchange;

* activity in options issued to the banks by the Bank of Israel—a negligible

component relative to the other two.

Contracts on the Stock Exchange are standard and the face value of the underlying

assets unit, the expiration date, and the exercise price are fixed. In OTC activity, in

contrast, the details of the contracts are worked out by the parties to the transactions,

i.e., banks and their customers and banks with each other.2 The Bank of Israel issues

three- and six-month put and call options.3 The NIS–forex derivatives market has

developed and become much more efficient in recent years in terms of trading

volumes and the number and diversity of participants. Therefore, it provides much

information about the market’s expectations as to future distribution of the exchange

rate, especially in regard to depreciation, appreciation, and volatility.

1. LEVELS OF ACTIVITY AND OPEN BALANCES

Activity in the NIS–forex derivatives market includes trading in options ( about 54 percent in 2004) and currency forward and swap transactions (about 46 percent). The levels of derivatives activity include all kinds of currencies4 and transactions among

Israeli banks.5

According to data for recent years, activity in options correlates strongly with the

level of exchange-rate risk (60 percent).6 This means that the level of options activity

is affected significantly by the factor of uncertainty. Forward and swap activity, in

1 Accurate analysis of activity of this kind is possible because the Department keeps a unique database

about OTC transactions at the individual-transaction level.2 Almost all trading in swaps and forwards takes place along the OTC channel.3 In the past, this was done to encourage the domestic derivatives market. Today, these options serve

as a source of information on the market’s evaluations.4 In December 2004, NIS-US$ activity accounted for 92 percent of total activity in derivatives on

the OTC track ($14.5 billion), NIS–euro—6 percent ($ 0.9 billion), and NIS–yen and NIS–Swiss franc

1 percent apiece. All transactions discussed here pertain to activity against NIS; activity among foreign

currencies is not included.5 The banks’ share in total OTC activity in December 2004 was 16 percent ($ 2.5 billion).6 Measured on the basis of the implied volatility of Bank of Israel options.

BANK OF ISRAEL, FOREIGN EXCHANGE ACTIVITY DEPARTMENT, ANNUAL REPORT, 2004

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contrast, has been relatively stable over time,7 evidently because swap transactions do

not directly affect, and are not affected by, the NIS–forex market. Therefore, they do

not correlate with exchange-rate risk as measured in terms of the implied volatility.

Some activity in the options market reflects hedging against exchange-rate changes; another part is “speculative” activity that is reflected in periods of high volatility. Most

activity in the options market takes place on the Tel Aviv Stock Exchange and along

the OTC channel, whereas activity in Bank of Israel options is negligible in volume

(Figure 2.3.1). Options activity does not behave identically on the exchange and in the

OTC market: activity on the exchange correlates strongly (67 percent) with exchange-

rate risk and OTC activity correlates weakly (only 13 percent). Consequently, activity

on the exchange is severely volatile while that on the OTC track is relatively stable.

The differences evidently trace to the nature and sophistication of the players that

transact in these markets, the duration and notional amounts of the transactions, and

market liquidity.

A glance at total activity in NIS–forex market derivatives shows that volumes were

stable (Figure 2.3.2) except in exceptional periods, the first halves of 2002 and 2003.

These spans of time were defined by events that affected the level of exchange-rate

risk—market instability due to ratecutting in late 2001 and the geopolitical situation

stemming from the war in Iraq (March 2003).

7 There is a negative correlation between this type of activity and the level of risk as measured by the

implied volatility.

PART II CHAPTER 3: DEVELOPMENTS IN THE NIS-FOREX DERIVATIVES MARKETS

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In the second quarter of 2003, exchange-rate risk began to trend down (as measured

on the basis of implied volatilities,8 reflected in the outlook on distribution of the

future exchange rate derived from option prices9) and options activity, foremost on

the Tel Aviv Stock Exchange, declined. Notably, the OTC track gives expression to

transactions that are tailored to customers’ needs in respect to term, exercise price,

and amount. Players in this market come from the nonfinancial domain (who have

hedging motives) or the financial domain and often carry out “strategies.”10 On the

Stock Exchange, options serve mainly as forex financial assets held by entities that

are not allowed to hold nontradable assets (mutual funds, among others). Thus, as the

level of exchange-rate risk and willingness to invest in forex decline, investment in

options traded on the exchange also declines. This effect was especially evident in the

third quarter of 2004.

The differences between the two tracks in terms of the players’ nature and motives and

of options activity, as stated, are reflected conspicuously in the number of transactions

8 See Part II Chapter 1 above, note 4.9 See section 2 below.10 “Strategies” are transactions that include more than one acquisition/sale of an asset. A straddle

transaction, for example, is composed of the acquisition or sale of a call option and a put option at the

same exercise price and on the same exercise day. The most common strategies in the OTC market are

straddle, strangle, reversal, and synthetic forward.


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(Figure 2.3.3). On the Stock Exchange track, the number of transactions has decreased

significantly in recent years (coupled with some increase in the size of the average transaction), whereas in OTC activity one encounters much fewer transactions but a very large balance of open positions (Figure 2.3.4). The main reasons are that the

average time to expiration is lengthier on the OTC track and that the Stock Exchange

is a high-liquidity track that allows traded options to be recycled extensively with no

change in the size of the open position.

2. THE INFORMATION IMPLIED IN NIS–DOLLAR OPTIONS

a. Comparative analysis of option prices in the three markets

The implied volatility trended down during the year and bottomed out in the third

quarter. The trend was evident in trading on all three channels.

The average implied volatilities in the three markets were different in 2004 (Figure

2.3.5) but the differences narrowed sharply at the end of the third quarter and the

beginning of the fourth quarter and widened again toward year’s end to the early-2004

level. Notably, the differences were very small; in the sample of options traded on the

Stock Exchange and OTC, exercise prices were limited to only 1 percent deviations


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from ATMF at the most11 (Figure 2.3.6). This suggests that market efficiency improved

and that the differences between the implied volatilities caused mainly by different

mixes of exercise prices in each market.12 The implied volatility of Bank of Israel

options is “cheaper” than that of options traded on the Stock Exchange and OTC.

One reason for this is that BOI options are issued solely on an ATMF basis whereas

options in the other two markets exhibit different exercise prices. This phenomenon,

in which the standard deviation of options with exercise prices other than ATMF is

more “expensive” than that of ATMF options, is known in the literature as the “smile

effect.” Comparison of Figures 2.3.5 and 2.c.6 also brings it to light.

b. The term structure of implied volatilities13

In 2004, the term structure of the implied volatility rose from left (short-term) to

right (longer-term) (Figure 2.3.7). The implied volatility in options to all terms of

exercise was low all year long, lowest in the third quarter, and higher toward year’s

end. The slope of the curve, in contrast, flattened. This may have reflected uncertainty

late in the year about the state budget and the stability of the government, with the

market expecting the uncertainty resulting from these factors to be short-lived and to

diminish, or at least not to increase, in 2005.

The term structure at times of especially severe uncertainty—such as late February

2002, after steep rate-cutting by the Bank of Israel (see window in figure)—typically

exhibits a negative slope.

A possible explanation for this is the market’s expectation that the uncertainty and

exceptional volatility of the exchange rate will be short-lived.

Empirical findings show that, as a rule, the implied volatility varies commensurate

the term to exercise of the options, even though the Black and Scholes options-pricing

model assumes that volatility of the underlying asset remains constant over time.

The “normal” term structure of the implied volatility, much like the time structure

of interest rates, rises from left to right. This is due to the greater uncertainty that

11 ATMF—“At the Money Forward”—for period t, computed in the following way:

ATMF=Se(Rnis–Rusd)t

where:

S—the NIS/dollar spot rate

t—the period (in years) remaining to the expiration of the option

RNIS—the return on Israel government Treasury bills for period t

RUSD—the LIBID interest rate on the dollar for period t.

The ATMF rate serves as a point of reference for the measurement of depreciation/appreciation

expectations.12 Bank of Israel options are issued for periods of three and six months only, at an exercise price

equal to the ATMF rate. On the Tel AvivStock Exchange, options are traded to terms of exercise of up to

a year at fixed exercise prices and tradable options are usually those with terms of exercise of up to two

months. In the OTC market, transactions may be concluded at any exercise price and to any term, most

transactions are for up to three months.13 See footnote 14.


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exists in longer terms—a tendency consistent with the assumption that the rate of

exchange-rate change is distributed normally.

c. Future exchange-rate distribution expectations as derived from prices of

options14

The NIS exchange rate was marked by stability in 2004, with low volatility and weak

expectations of minor exchange-rate changes. However, the behavior of the exchange

rate was uneven during the year. The quarter-by-quarter review that follows is based

on two NIS/dollar exchange-rate

forecasts derived using two different

approaches.

Fan charts of forecasts of the NIS/$ exchange rate:15: 2004 was noted for expectations of mild exchange-

rate volatility (Figure 2.c.8). Lower

volatility was expected in quarters II–

IV than in quarters I-2004 and I-2005.

However, expected volatility in I-2005

was not different from the 2004 level

and was much lower than the outlook

for I-2003, when severe volatility was

expected due to the impending war in

Iraq. These expectations came to pass:

the NIS/dollar exchange rate was less

volatile in 2004 than in 2002 and 2003

(Figure 2.a.5).

This forecast rests on the assumption

of normality in the distribution of

exchange-rate changes. Under this

assumption, the future exchange-rate

distribution is estimated using the

ATMF rate (derived from the spot

rate, the difference in interest rates,

and the period remaining to option

exercise) and the implied volatility of

the options.16

14 The analysis is based on data on OTC options trading.15 For a detailed explanation about how the outlook is computed, see Foreign Exchange Activity

Department, “Information Implied in the Forex Derivatives Market,” September 2003 (Hebrew).16 A normal distribution is characterized by two parameters only: expectation and variance.


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Forecast of the exchange-rate distribution from the probability of exercise N(d2) of NIS–dollar options17 shows that mild appreciation relative to ATMF was expected in 2004 (expectations of depreciation/appreciation are measured on the basis of the

position of the maximum point)18 whereas the outlook for I-2005 points to expectations

of no exchange-rate change relative to ATMF (Figure 2.3.9). Notably, the appreciation

expectations did come to pass except in the first quarter and appreciation in the last

quarter surpassed expectations. As for volatility—measured on the basis of the

width of the curve—the outlook for I-2004 pointed to estimations of rather strong

volatility, evidently due to uncertainty about the effect of the tax reform on exchange-

rate changes. The outlooks for quarters II–IV, in contrast, indicated a decline in the

expected volatility. Indeed, actual volatility during these quarters was mild. (For a

detailed explanation about the factors that affect activity in the NIS–forex market, see

Part II Chapter 1.) The volatility expectation for I-200519 resembled that for I-2004.

This, as stated, may trace to uncertainty about the stability of the government and the

passage of the state budget.

17 See footnote 15.18 Figure 2.3.9, constructed on the basis of this methodology, shows depreciation or appreciation

expectations in view of the location of the maximum point relative to the ATMF rate. A point to the right

of ATMF indicates expectations of depreciation relative to ATMF; a point to the left of ATMF indicates the

opposite. The farther from ATMF the maximum point is, the more intensive the depreciation/appreciation

expectations are. Additionally, the width of the curve gives information about expected exchange-rate

volatility: the narrower the curve, the less volatility is expected.19 This forecast is grounded in the fact that the expression N(d2) in the Black and Scholes formula

reflects expectations that the option will be exercised, i.e., in the case of a call option, the expectation

that the NIS/dollar exchange rate will be higher than the exercise price of the option. Therefore, one may

derive the density function of the distribution and, in particular, predict the direction and intensity of the

expected future exchange-rate change and volatility.

chapter 3 developments in the nis-forex derivatives markets · 2012. 7. 8. · 121 chapter 3...

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