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Modelling Exchange Rates in Continuous Time: Theory, Estimation and Option Pricing

Author

Listed:
  • William Perraudin

    (University of Cambridge)

  • Bent Sørensen

    (Brown University)

Abstract

Recent research on contingent claims valuation has assumed increasingly general models of the behavior of cash securities. Relatively few attempts have been made to implement and evaluate such models empirically, however. In this paper we apply a multi-factor, continuous time pricing model to foreign exchange and interest rate data for five countries. The model allows for: (i) stochastic volatility, (ii) non-diversifiable jump risk, and (iii) stochastic interest rates. Using simulations, we examine the significance of different features of the model for option pricing. We conclude that, at least for our data set, jumps and stochastic volatility have little impact on option pricing, if one knows the average volatility over the life of the option. However, the inclusion and precise specification of stochastic interest rates are surprisingly important.

Suggested Citation

  • William Perraudin & Bent Sørensen, 1994. "Modelling Exchange Rates in Continuous Time: Theory, Estimation and Option Pricing," Discussion Papers 94-16, University of Copenhagen. Department of Economics.
    • Handle: RePEc:kud:kuiedp:9416
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    Cited by:

    1. Andersen, Torben G & Sorensen, Bent E, 1996. "GMM Estimation of a Stochastic Volatility Model: A Monte Carlo Study," Journal of Business & Economic Statistics, American Statistical Association, vol. 14(3), pages 328-352, July.

    More about this item

    Keywords

    exchange rate models; option pricing; GMM; stochastic volatility; jump risk;
    All these keywords.

    JEL classification:

    • F30 - International Economics - - International Finance - - - General
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models

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