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Stress Testing FX Option Risk During a Move to Floating Rates

Article Quant Q&A · Author: SquaredCircle
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Summary

The document addresses risk management for an over-the-counter vanilla FX option book as Morocco transitions toward a floating exchange rate. It identifies two exposures to consider: a period of elevated currency volatility and a large one-time repricing of the dirham against other currencies. It does not specify a single optimal hedge or a volatility assumption.

For the discrete move risk, the answer proposes holding non-dirham exchange rates fixed, varying EUR/MAD across a range of scenarios, repricing the option book, and examining profit and loss and option Greeks across those levels. Vega can help assess the effect of implied-volatility changes, while gamma may dominate when the exchange rate makes a large jump. The suggested range is illustrative, not calibrated to forecasts or market data, and the document does not provide a full simulation framework or address how the book’s specific positions alter the result.

Key ideas

  • A currency regime change can raise volatility across related exchange rates and create jump risk.
  • Stress testing can reprice the option book across assumed EUR/MAD levels while holding other exchange rates fixed.
  • Profit and loss and Greeks across scenarios help reveal how the book responds to a large move.
  • Gamma exposure from a sharp exchange-rate shift may outweigh the vega effect, depending on the portfolio.

Tags

ForexOptionsRisk managementDerivatives pricing
Full text
# book of options hedging case of floating rate


# book of options hedging case of floating rate












i'm an intern in bank at Morocco that sells vanilla options on EUR/USD , EUR/MAD , USD/MAD , it s using delta hedging strategy to cover they're position . But because of the switch to floating exchange rate of morocco in the next months , the bank is wondering how it will be cover its book of options and which strategy is optimal in this case , is there any technique to simulate this ? What volatility should i consider in this case ? PS : Options are sold OTC

Thanks in advance

## Answer by Bram (score 1)

https://quant.stackexchange.com/a/32903

The question of how to hedge an option portfolio on multiple underlyings against tail risks is not an easy one, nor what with a single answer.

There are probably two big risks: - a period of increased volatility in all currencies versus MAD until the MAD settles down that the market believes to be right - a big one-off P&L on a big move on MAD versus all other currencies.

For the latter, you could do an analysis where you assume all non-MAD exchange rates fixed and you let EUR/MAD vary from -20% to +20% (or whatever bounds people are expecting). Reevaluating the book with all xxx/MAD implied levels from those and then looking at the P&L and greeks versus the level should give you an idea of whether you're comfortable with the risks. You could look at vega here and estimate the impact of that on your P&L, but my expectation (without knowing anything of your book) is that the gamma impact from a big one-off move to a new level of trading might dwarf whatever your vega P&L might do.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.