Efficiency of Option Market as an Exchange Rate Risk Hedging Instrument

Abstract

Since 1999, Colombia adopted an exchange rate regime in which the United States dollars/Colombian pesos (USD/COP) exchange rate is floating. This means that quoted prices in the market of this currency depend on the existing supply and demand. In some instances, Banco de la República intervenes in the purchase or sale of currencies (dollar) in order to regulate the prices slightly. This paper presents the empirical validation of the options as hedging instruments, some inefficiencies of this financial instrument were found due to their low availability and high transaction costs in the use of this asset as an exchange risk hedging instrument. The goal of this study was validate the USD/COP options assets as hedging instruments of exchange risk, that has not yet studied on Colombian companies, who carry out foreign currency transactions; The present study argues the importance for the companies to use a hedging strategy to diversify the exchange rate risk; consequently, companies who perform currency operations (with dollars in this case) must include operations to manage financial risks in the USD/COP exchange rate through financial instruments, such as the exchange rate options contracts, to reduce transaction costs. For this, the spot prices and USD/COP options between 2011 and 2018, found in the Colombian stock exchange, were analyzed by valuing its risk through the VaR (value at risk), evaluating its impacts as a risk-hedging instrument in the exchange rate, and comparing hedging effects through a Sharpe ratio model (