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

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Author Info

  • 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.

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File URL: http://www1.wiwi.uni-muenster.de/cqe/forschung/publikationen/cqe-working-papers/CQE_WP_10_2010.pdf
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Bibliographic Info

Paper provided by Center for Quantitative Economics (CQE), University of Muenster in its series CQE Working Papers with number 1010.

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Length: 31 pages
Date of creation: Jan 2010
Date of revision:
Handle: RePEc:cqe:wpaper:1010

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Related research

Keywords: Interest-rate dynamics; valuation of interest-rate options; currency union;

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  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.
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