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Realignment risk and currency option pricing in target zones

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  • Dumas, Bernard
  • Peter Jennergren, L.
  • Naslund, Bertil

Abstract

This paper extends the Krugman target zone model by including a realignment mechanism. Various properties of that realignment mechanism are discussed. The movement of the exchange rate is governed both by a Wiener process on fundamental and by a Poisson jump process with endogenous realignment size. The realignment mechanism is such that (except in cases where a speculative attack occurs) no jump in fundamental is needed to accompany the jump in the exchange rate. A risk neutral valuation of currency options is constructed. Some properties of option values under realignment risk are illustrated by numerical results.

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Bibliographic Info

Article provided by Elsevier in its journal European Economic Review.

Volume (Year): 39 (1995)
Issue (Month): 8 (October)
Pages: 1523-1544

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Handle: RePEc:eee:eecrev:v:39:y:1995:i:8:p:1523-1544

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References

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  2. Andrew K. Rose & Lars E.O. Svensson, 1991. "Expected and predicted realignments: the FF/DM exchange rate during the EMS," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 395, Board of Governors of the Federal Reserve System (U.S.).
  3. Merton, Robert C., 1975. "Option pricing when underlying stock returns are discontinuous," Working papers 787-75., Massachusetts Institute of Technology (MIT), Sloan School of Management.
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  5. Robert P. Flood & Andrew K. Rose & Donald J. Mathieson, 1990. "An Empirical Exploration of Exchange Rate Target-Zones," NBER Working Papers 3543, National Bureau of Economic Research, Inc.
  6. Dumas, B. & Jennergren, L.P. & Naslund, B., 1993. "Currency Option Pricing in Credible Target Zones," Weiss Center Working Papers, Wharton School - Weiss Center for International Financial Research 93-7, Wharton School - Weiss Center for International Financial Research.
  7. Bertola, G. & Svensson, L.E., 1990. "Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models," Papers, Stockholm - International Economic Studies 481, Stockholm - International Economic Studies.
  8. Lars E. O. Svensson, 1990. "Target Zones and Interest Rate Variability," IMF Working Papers 90/31, International Monetary Fund.
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  21. Orlin J. Grabbe, . "The Pricing of Call and Put Options on Foreign Exchange," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 6-83, Wharton School Rodney L. White Center for Financial Research.
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Citations

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Cited by:
  1. Lioui, Abraham, 1998. "Currency risk hedging: Futures vs. forward," Journal of Banking & Finance, Elsevier, Elsevier, vol. 22(1), pages 61-81, January.
  2. Mundaca, Gabriela, 2003. "A Drift of the "Drift Adjustment Method"," Memorandum, Oslo University, Department of Economics 16/2002, Oslo University, Department of Economics.
  3. Mordecai Avriel & Jens Hilscher & Alon Raviv, 2013. "Inflation Derivatives Under Inflation Target Regimes," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 33(10), pages 911-938, October.
  4. Rahel Studer-Suter & Alexandra Janssen, 2014. "The Swiss franc's honeymoon," ECON - Working Papers, Department of Economics - University of Zurich 170, Department of Economics - University of Zurich.
  5. Bardhan, Indrajit, 1995. "Exchange rate shocks, currency options and the Siegel paradox," Journal of International Money and Finance, Elsevier, Elsevier, vol. 14(3), pages 441-458, June.
  6. Christian Pierdzioch, 2000. "The Effectiveness of the FX Market Interventions of the Bundesbank During the Louvre Period: An Options-Based Analysis," Kiel Working Papers 971, Kiel Institute for the World Economy.
  7. Ekvall, Niklas & Peter Jennergren, L. & Naslund, Bertil, 1997. "Currency option pricing with mean reversion and uncovered interest parity: A revision of the Garman-Kohlhagen model," European Journal of Operational Research, Elsevier, Elsevier, vol. 100(1), pages 41-59, July.
  8. Young-Kyu Moh, 2006. "Continuous-time model of uncovered interest parity with regulated jump-diffusion interest differential," Applied Economics, Taylor & Francis Journals, Taylor & Francis Journals, vol. 38(21), pages 2523-2533.
  9. Rangvid, Jesper & Sorensen, Carsten, 2001. "Determinants of the implied shadow exchange rates from a target zone," European Economic Review, Elsevier, Elsevier, vol. 45(9), pages 1665-1696, October.
  10. Dumas, B. & Jennergren, L.P. & Naslund, B., 1993. "Currency Option Pricing in Credible Target Zones," Weiss Center Working Papers, Wharton School - Weiss Center for International Financial Research 93-7, Wharton School - Weiss Center for International Financial Research.
  11. Naszódi, Anna, 2004. "A sáveltolás árfolyamhatásának vizsgálata opciós modell keretei között
    [Target-zone rearrangement and exchange-rate behaviour in an options-based model]
    ," Közgazdasági Szemle (Economic Review - monthly of the Hungarian Academy of Sciences), Közgazdasági Szemle Alapítvány (Economic Review Foundation), vol. 0(7), pages 638-658.
  12. Naszódi, Anna, 2002. "A sávos árfolyamú deviza megközelítése opciók segítségével
    [The option-based description of the exchange rate in a target-zone system]
    ," Közgazdasági Szemle (Economic Review - monthly of the Hungarian Academy of Sciences), Közgazdasági Szemle Alapítvány (Economic Review Foundation), vol. 0(1), pages 25-44.

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