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Foreign exchange option pricing in the currency cycle with jump risks

Author

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  • Chien-Hsiu Lin
  • Shih-Kuei Lin
  • An-Chi Wu

Abstract

This paper examines regime switching behavior and the nature of jumps in foreign exchange rates, as well as their implications in currency option pricing. Considering the characteristics of long swing as well as the short term jumps in exchange rates, we adopt the regime-switching model with jump risks to capture the movement of exchange rates in the developed and emerging countries. Our results show that ‘high-variance’ and ‘low-variance’ describes most of our sample currencies’ trajectories. The regime-switching model with jump risks is proven to capture better exchange rate changes than the regime-switching model (RSM) and the Black–Scholes model (BSM). In addition, our results show that the currency option pricing model when considering regimes of high-variance or low-variance states as well as the jump nature of exchange rates, is better than the traditional BSM and RSM. Copyright Springer Science+Business Media New York 2015

Suggested Citation

  • Chien-Hsiu Lin & Shih-Kuei Lin & An-Chi Wu, 2015. "Foreign exchange option pricing in the currency cycle with jump risks," Review of Quantitative Finance and Accounting, Springer, vol. 44(4), pages 755-789, May.
    • Handle: RePEc:kap:rqfnac:v:44:y:2015:i:4:p:755-789
    DOI: 10.1007/s11156-013-0425-1
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    Cited by:

    1. Hsu, Yuan-Lin & Lin, Shih-Kuei & Hung, Ming-Chin & Huang, Tzu-Hui, 2016. "Empirical analysis of stock indices under a regime-switching model with dependent jump size risks," Economic Modelling, Elsevier, vol. 54(C), pages 260-275.
    2. Konstantinos Gkillas & Rangan Gupta & Mark E. Wohar, 2020. "Oil shocks and volatility jumps," Review of Quantitative Finance and Accounting, Springer, vol. 54(1), pages 247-272, January.
    3. Shin-Yun Wang & Ming-Che Chuang & Shih-Kuei Lin & So-De Shyu, 2021. "Option pricing under stock market cycles with jump risks: evidence from the S&P 500 index," Review of Quantitative Finance and Accounting, Springer, vol. 56(1), pages 25-51, January.
    4. Chen, Son-Nan & Hsu, Pao-Peng, 2018. "Pricing and hedging barrier options under a Markov-modulated double exponential jump diffusion-CIR model," International Review of Economics & Finance, Elsevier, vol. 56(C), pages 330-346.
    5. Chuang, Ming-Che & Wen, Chin-Hsiang & Lin, Shih-Kuei, 2020. "Valuation and empirical analysis of currency options," International Review of Economics & Finance, Elsevier, vol. 66(C), pages 71-91.

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    More about this item

    Keywords

    Exchange rate; Currency option; Regime-switching; Jump risks; C58; F31; G13;
    All these keywords.

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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