Currency options may increase Singapore dollar volatility

Currency options may increase Singapore dollar volatility

SINGAPORE (Dow Jones): The Monetary Authority of Singapore's move last week to loosen rules on onshore currency options trading may be a signal that it's prepared to let the local dollar fluctuate more widely - if not exactly wildly, analysts say.

To attract more interest in Singapore dollar options, used to hedge positions, the authorities will need to allow sufficient volatility in the underlying instrument - in this case the Singapore currency.

"When you introduce options, you need to allow greater volatility," says Jimmy Koh, the head of treasury research at UOB Group. "They will probably need to widen the Singapore dollar trading band."

Last week, the Monetary Authority of Singapore, the republic's de facto central bank, announced it would allow banks to transact Singapore dollar-denominated currency options with other banks and financial institutions it now regulates.

The move, which came into effect Dec. 6, was aimed at facilitating the use of currency options as hedging instruments. A currency option is a contract between a buyer and seller which gives the buyer the right, but not the obligation, to trade a specific amount of currency at a predetermined price and within a predetermined period of time, regardless of the market price of the currency.

Allowing interbank trading in Singapore dollar options was part of a package of measures unveiled last week designed to increase foreign investment in the domestic capital market.

"It makes the whole process of price-making more efficient," says a currency options specialist at a U.S. bank. "There was a fair amount of options trading going on between customers and banks, but having an interbank market now makes the whole process more efficient."

Last week, the MAS also announced that it would allow banks to lend local dollars to nonresidents for investment purposes in Singapore. Banks can also extend Singapore dollar credit facilities to nonresidents to fund offshore activities as long as the Singapore dollar proceeds are converted into foreign currency.

The change effectively widens the use of the Singapore dollar, the control of which the MAS has long been reluctant to give up. It uses the currency, not interest rates, as its primary monetary policy tool. The movement of the Singapore dollar is guided within an undisclosed trading band against a basket of currencies of the country's major trading partners.

The Singapore dollar trades within very narrow daily ranges on average, as the MAS regularly steps into the market to smooth out volatile trading. In the last 10 trading days, for instance, the Singapore dollar fluctuated within an average 60-pip daily range.

Even with the introduction of an onshore currency options market, important restrictions will remain, ensuring that the authority retains the ability to keep a tight grip on the Singapore dollar if it so chooses. For example, restrictions disallow the development of an offshore options market - which would potentially pose a challenge to the authority's control in the event of speculative attacks against the local dollar.

Still, the move to allow an onshore market for options was somewhat revolutionary, some said.

"I was a little bit surprised. It (allowing currency options trading) happened quite suddenly," says a European bank options desk head. "Their main concern was that in opening up the market, it would create more volatility in the spot."

Koh at UOB Group adds the MAS didn't have much of a choice. "If you want to fire up the domestic debt market, you need to provide an environment for people to hedge their positions."

The MAS has been trying hard to develop various segments of the financial sector, including the debt market, as a way of shifting focus from foreign exchange trading, a previously strong money earner but which is fast losing importance to the more exotic areas of derivatives.

The impact of currency options on Singapore dollar spot trading has been muted so far. Interest in Singapore dollar- denominated currency options has slackened off following an initial exuberance, as year-end lethargy saps life out of Asian currency options markets, dealers say.

"Hedging activity is pretty much on the low side. It's not only in Sing dollar that volume's low," said a U.S. bank dealer. "There's hardly anything done in the baht now."

Daily trading volume in Singapore dollar options has been halved to about $20 million to $30 million a day, from a "decent" volume of around $60 million at its debut, as the authority's consent triggered an initial flurry of excitement, dealers say.

In comparison, daily trading volume in the Taiwan dollar options averages about $70 million to $80 million, while Thai baht options have been barely traded ever since the Thai authorities clamped down on speculative trading in the currency a few weeks ago, dealers say.

Experts say they expect trading volumes in Singapore dollar options to improve next year. Although only about half of the banks in Singapore have participated in this market, more are expected to join the bandwagon, dealers say.