Using Copulas to Construct Bivariate Foreign Exchange Distributions with an Application to the Sterling Exchange Rate Index
AbstractWe model the joint risk neutral distribution of the euro-sterling and the dollar-sterling exchange rates using option-implied marginal distributions that are connected via a copula function that satisfies the triangular no-arbitrage condition. We then derive a univariate distribution for a simplified sterling effective exchange rate index (ERI). Our results indicate that standard parametric copula functions, such as the commonly used Normal and Frank copulas, fail to capture the degree of asymmetry observed in the data. We overcome this problem by using a non-parametric dependence function in the form of a Bernstein copula, which is shown to produce a very close fit. We further give an example of how our approach can be used to price currency index options.
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Bibliographic InfoPaper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5114.
Date of creation: Jun 2005
Date of revision:
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Other versions of this item:
- Christoph Schleicher & Matthew Hurd & Mark Salmon, 2005. "Using Copulas to Construct Bivariate Foreign Exchange Distributions with an Application to the Sterling Exchange Rate Index," Computing in Economics and Finance 2005 215, Society for Computational Economics.
- Matthew Hurd & Mark Salmon & Christoph Schleicher, 2007. "Using copulas to construct bivariate foreign exchange distributions with an application to the sterling exchange rate index," Bank of England working papers 334, Bank of England.
- F31 - International Economics - - International Finance - - - Foreign Exchange
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
This paper has been announced in the following NEP Reports:
- NEP-ALL-2005-08-13 (All new papers)
- NEP-FIN-2005-08-13 (Finance)
- NEP-FMK-2005-08-13 (Financial Markets)
- NEP-IFN-2005-08-13 (International Finance)
- NEP-MON-2005-08-13 (Monetary Economics)
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