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An exact pricing formula for European call options on zero-coupon bonds in the run-up to a currency union

Author

Listed:
  • Gerrit Reher
  • Bernd Wilfling

Abstract

In this paper we analyze the dynamics of zero-coupon bond options in a situation in which two open economies plan to enter a currency union in the future. More precisely, we make use of recent theoretical work on the continuous-time dynamics of interest-rate differentials between the economies involved and derive a closed-form pricing formula for a European call option on zero-coupon bonds. In a Monte-Carlo simulation study we show that significant option-pricing errors can occur when the key features of interest-rate dynamics during the run-up to the currency union are ignored.

Suggested Citation

  • Gerrit Reher & Bernd Wilfling, 2010. "An exact pricing formula for European call options on zero-coupon bonds in the run-up to a currency union," CQE Working Papers 1010, Center for Quantitative Economics (CQE), University of Muenster.
    • Handle: RePEc:cqe:wpaper:1010
    as

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    File URL: https://www.wiwi.uni-muenster.de/cqe/sites/cqe/files/CQE_Paper/CQE_WP_10_2010.pdf
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    References listed on IDEAS

    as
    1. David Sondermann & Mark Trede & Bernd Wilfling, 2011. "Estimating the degree of interventionist policies in the run-up to EMU," Applied Economics, Taylor & Francis Journals, vol. 43(2), pages 207-218.
    2. De Grauwe, Paul & Dewachter, Hans & Veestraeten, Dirk, 1999. "Price dynamics under stochastic process switching: some extensions and an application to EMU1," Journal of International Money and Finance, Elsevier, vol. 18(2), pages 195-224, February.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Interest-rate dynamics; valuation of interest-rate options; currency union;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications

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