The right of the holders of a given local currency to dispose of their currency holdings in exchange for goods and services or foreign currencies. From the perspective of a central bank balance sheet, local currency holders have the right to dispose of their holdings by exercising the embedded convertibility option against a premium constituting a part of currency seigniorage. In this sense, local currency holdings can be viewed as a liability with option-like features.
Upon exercise, the option obliges the central bank to reduce its assets (gold, international reserves, etc) in proportion to the decrease in local currency holdings. Central banks can/should respond to such a currency disposal by reducing credit and liquidating international reserves. Otherwise, higher inflation and/or currency devaluation ensue.
The value of a currency liability option is determined as the present economic value of the flow of goods and services provided by local currency minus the present economic value of buying goods and services or holding foreign currency. Therefore, a holder of domestic currency is said to have a long position in a put “convertibility option“. This option will not be exercised if the present economic value of local currency is believed to be exceeding that of holding goods or foreign exchange.
This option is also referred to as sovereign-linked currency swaption.
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