Currency Options, Implied Interest Rates and Inflation Targeting

Abstract

The currency option price is a powerful tool used regularly to determine market expectations on volatility in currencies using the implied volatility measure. This research tests and analyzes whether similar inferences can be made regarding interest rate and inflation expectations. Using historical options data, we derive and analyze implied interest rates during non-inflation targeting (non-IT) and inflation targeting (IT) periods for Australia, Canada, and the United Kingdom. We compare the results to a control group of countries that had not yet adopted inflation targeting during the period under study: Germany, Japan and Switzerland. Our results show that options prices can provide insights on market expectations on interest rates, that the adoption of inflation targeting strengthens the relationship between market expectations and inflation, and that shocks in interest rates and inflation lead to higher implied interest rates. In determining the potential uses of implied interest rates derived from currency options prices, our goal is not to replace the Federal Funds futures or equivalent tools in advanced economies, rather to present the usefulness of currency options as a tool to provide information to policymakers in emerging market economies. Central banks, such as the Banco Central de Colombia and Banco de Mexico, have been using currency options as tools for foreign exchange intervention or reserve accumulation/decumulation since the early 2000’s, and options markets in these economies have grown rapidly since then. Therefore, establishing the usefulness of implied interest rate measures derived from currency options prices may provide insights to policymakers and practitioners alike.