The Implied Subsidy of Exchange Rate Mechanisms

This paper proposes an unconventional method for analyzing the cost of foreign exchange rate mechanisms using option pricing theory. The insurance coverage embedded in the exchange rate regime is analogous to a currency option (or a portfolio of currency options) whose pay-off can be explicitly calculated. The value of such option (or portfolio) can be considered a (shadow) subsidy. For example a target zone arrangement between two currencies is equivalent to a perpetual strangle (a portfolio consisting of a call and a put) with strike prices equal to the limits of the band. Analogously a fixed exchange rate is equivalent to a perpetual straddle (a portfolio consisting of a call and a put with the same strike prices). An exact evaluation of the subsidy depends on a number of hypotheses: this paper provides some estimates under different assumptions using an extension of the Garman (1987) formula for pricing perpetual currency options