I'm wondering what's the standard (if any) for practitioners to trade volatility on pegged currencies. Is there any specific convention? I'm thinking situations like EURCHF before the unpeg, how were people trading this via options and how were those options priced?
As for the model to price this, I would imagine something mean-reverting with some jumps, is there any material or info you can share on this?
This is a good question. Within the space of pegged currencies the modeling and valuation approach varies. I can speak from trading the gulf ccys (USDSAR and USDAED specifically). These petrodollar driven economies have two fundamental dimensions to the peg: the price of oil and inflation in the US (because due to the peg the interest rates markets of SAR and AED are intimately linked to the US rates market). The ATM FX vols are virtually null (of the order of 0.5-1%) and short-dated ATM vol is "yours all day". But the crucial issue is in pricing the skew (the de-pegging risk). This fluctuates with the inflation differential with the US - de-pegging is higher risk of occurring if there is wide variation in the inflation differential via imported inflation. The same goes with high oil price volatility. As to how to price this skew... this is one of those markets which is very much driven by demand/supply of these OTM options (which again comes from the aforementioned factors) - a finger in the air approach if you will. There really is no quantifiable methodology for pricing this skew that I am aware of. The supply of the skew generally comes from local corporates (who have no MTM considerations) via structured transactions. The issue for dealers generally always is overpricing the skew and bleeding theta trying to get rid of it. Not an exact science at all.
I remember when people were trading a lot of FX options, as well as forwards on USDARS in 2001, before AR defaulted, and the currency peg broke. USDARS was pegged to 1, so there was no historical volatility... but most market participants expected the peg to break soon, the interets rate for borrowing ARS was well into double digits, and together the the (symmetric) implied volatility and risk reversals for the options, and the forward rates, expressed the traders' views on how much / how soon ARS would devalue. No one expected it to appreciate v USD for sure.
These days, if no one expects a peg to break, the motivation for trading options or forward on something like constant USDXCD is not to express the view that the peg would break, but rather to show some accountant types that the market risk is hedged, or to provide this hedging service to those wanting it... so the pricing is driven more by the willingness to provide the service.
