Liquidity and Efficiency in Three Related Foreign Exchange Options Markets

Abstract

The foreign currency market in a small open economy, like Israel, plays a major role in fiscal and monetary policy decisions, through its effects on the financial markets and the real economy. In this paper we explore the liquidity and efficiency in three related foreign exchange options markets and the information content of the instruments traded in these markets. The unique data set on OTC trading and the central bank auctions, in addition to the exchange traded options provide us with insights about the operation of these markets, their relative efficiency, their information content and their interrelationship. An important aspect is the effect of liquidity on the pricing of options in these markets. As expected, we find that, except for extreme cases, liquidity does not affect options prices.

Keywords: Foreign Exchange, Implied Volatility, Liquidity, Bid-Ask Spread

JEL Classification: F31, G13, G14