On Model Robustness of the Regime Switching Approach for Pegged Foreign Exchange Markets

25 Pages Posted: 17 Mar 2021 Last revised: 8 Sep 2021

See all articles by Yunbo Zhang

Yunbo Zhang

Shanghai Jiao Tong University (SJTU) - School of Mathematical Sciences

Samuel Drapeau

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF); Shanghai Jiao Tong University (SJTU) - School of Mathematical Sciences

Date Written: March 16, 2021

Abstract

We test the robustness of the regime switching model for pegged markets introduced in S. Drapeau, T. Wang, T. Wang (2021). In particular, two disputable underlying assumptions: 1) A Black and Scholes model with low volatility for the pre-depegging regime. 2) A thin tail distribution - Poisson type - for the time of the depegging. For the pre-depegging regime, we consider a bounded model within the peg -- from Ingersoll and Rady. For the depegging time, we consider fat tail distributions more in line with catastrophic events -- Pareto/Fr\'echet. We derive the option prices formula for each combination of these models. We then calibrate to option data from Hong Kong Dollars as well as Swiss Franc FX markets. In comparison to the benchmark model in S. Drapeau, T. Wang, T. Wang (2021), it turns out that the relevant resulting characteristics -- probability of a depegging before maturity, appreciation/depreciation at the depegging time as well as post-depegging volatility -- are strongly robust in terms of model choice for this regime switching approach. However, from a term structure perspective, fat tail distributions fit the data significantly better and provide more rational depegging probabilities for short and long maturities.

Keywords: FX Markets, Pegged Exchange Rate, USD-HKD, EUR-CHF, Regime Switching, Option Pricing, Calibration

JEL Classification: C02, C52, G13, G15

Suggested Citation

Zhang, Yunbo and Drapeau, Samuel, On Model Robustness of the Regime Switching Approach for Pegged Foreign Exchange Markets (March 16, 2021). Available at SSRN: https://ssrn.com/abstract=3805405 or http://dx.doi.org/10.2139/ssrn.3805405

Yunbo Zhang

Shanghai Jiao Tong University (SJTU) - School of Mathematical Sciences ( email )

Dongchuan Road 800
Shanghai, Shanghai
China

Samuel Drapeau (Contact Author)

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

HOME PAGE: http://www.samuel-drapeau.info

Shanghai Jiao Tong University (SJTU) - School of Mathematical Sciences ( email )

Dongchuan Road 800
Shanghai, Shanghai
China

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