Normality, Modal Risk Level, and Exchange-Rate Jumps

16/02/2005 |  Hecht Yoel, Pomposhko Helena
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The Foreign Exchange Market
Normality, Modal Risk Level, and Exchange-Rate Jumps
Yoel Hecht and Helena Pompushko

Abstract

This article presents three indexes that may be used to examine the expected exchange rate as reflected in trading in exchange-rate options. With these indexes one may examine, on a daily basis, whether the expectations of exchange-rate change were determined in a normal-distribution environment (hereinafter: the “N-Index”), the modal risk level in the forex market (hereinafter: the “R-Index”), and the expected direction and intensity of exchange-rate change in the event of an exchange-rate jump (hereinafter: the “J-Index”).

We applied the indexes to daily trading in NIS/dollar exchange-rate options on the Tel Aviv Stock Exchange. By analyzing the indexes for the October 2002–June 2004 period, we found that even though the NIS appreciated perceptibly against the dollar (about 10 percent in the first half of 2003), the Israeli public continued to associate the exchange-rate risk with depreciation: When the N-Index reflected an abnormal market environment and the R-Index reflected a high modal risk level, the J-Index reflected expectations of an exchange-rate jump only in the direction of depreciation.

One of the possible reasons for the decrease in the forex sector’s contribution to financing activity earnings in the Israeli banking system in 2003 (Supervisor of Banks, 2004) may have been the rather severe misalignment between the expected behavior of the exchange rate and its de facto behavior.

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