Trading Frequency and Implied Transaction Costs of Foreign Exchange Options

This study explores the viability of arbitrage in determining the price of foreign exchange options when adjustments of the replicating asset portfolio are subject to transaction costs. We first develop a model for valuing those options and then use empirical data and simulation to calculate the bid-ask spread consistent with various levels of transaction costs and trading frequencies. Our findings show that the price spread implied by feasible cost and trading interval parameters is fairly narrow, indicating a role for arbitrage in that market. Our estimated low transaction costs suggest that the market for currency options is dominated by institutional investors