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Realignment Risk and Currency Option Pricing in Target Zones

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  • Bernard Dumas
  • L. Peter Jennergren
  • Bertil Naslund

Abstract

This paper extends the Krugman target zone model by including a realignment mechanism. Various properties of that realignment mechanism are discussed. The movement of the exchange rate is governed both by a Wiener process on fundamental and by a Poisson jump process with endogenous realignment size. The realignment mechanism is such that (except in cases where a speculative attack occurs) no jump in fundamental is needed to accompany the jump in the exchange rate. A risk neutral valuation of currency options is constructed. Some properties of option values under realignment risk are illustrated by numerical results.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4458.

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Date of creation: Sep 1993
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Publication status: published as European Economic Review, Vol. 39, (1995), pp. 1523-1566.
Handle: RePEc:nbr:nberwo:4458

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  1. Orlin Grabbe, J., 1983. "The pricing of call and put options on foreign exchange," Journal of International Money and Finance, Elsevier, Elsevier, vol. 2(3), pages 239-253, December.
  2. Kenneth A. Froot & Maurice Obstfeld, 1992. "Exchange Rate Dynamics Under Stochastic Regime Shifts: A Unified Approach," NBER Working Papers 2835, National Bureau of Economic Research, Inc.
  3. Paul R. Krugman, 1988. "Target Zones and Exchange Rate Dynamics," NBER Working Papers 2481, National Bureau of Economic Research, Inc.
  4. Orlin J. Grabbe, . "The Pricing of Call and Put Options on Foreign Exchange," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 6-83, Wharton School Rodney L. White Center for Financial Research.
  5. Akgiray, Vedat & Booth, G Geoffrey, 1988. "Mixed Diffusion-Jump Process Modeling of Exchange Rate Movements," The Review of Economics and Statistics, MIT Press, vol. 70(4), pages 631-37, November.
  6. Delgado, Francisco & Dumas, Bernard, 1993. "Monetary contracting between central banks and the design of sustainable exchange-rate zones," Journal of International Economics, Elsevier, Elsevier, vol. 34(3-4), pages 201-224, May.
  7. Paul Krugman & Marcus Miller, 1992. "Exchange Rate Targets and Currency Bands," NBER Books, National Bureau of Economic Research, Inc, number krug92-1, October.
  8. Obstfeld, Maurice & Stockman, Alan C., 1985. "Exchange-rate dynamics," Handbook of International Economics, Elsevier, in: R. W. Jones & P. B. Kenen (ed.), Handbook of International Economics, edition 1, volume 2, chapter 18, pages 917-977 Elsevier.
  9. Flood, Robert P & Garber, Peter M, 1991. "The Linkage between Speculative Attack and Target Zone Models of Exchange Rates," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 106(4), pages 1367-72, November.
  10. Tucker, Alan L & Pond, Lallon, 1988. "The Probability Distribution of Foreign Exchange Price Changes: Tests of Candidate Processes," The Review of Economics and Statistics, MIT Press, vol. 70(4), pages 638-47, November.
  11. Merton, Robert C., 1975. "Option pricing when underlying stock returns are discontinuous," Working papers 787-75., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  12. Andrew K. Rose & Lars E.O. Svensson, 1991. "Expected and predicted realignments: the FF/DM exchange rate during the EMS," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 395, Board of Governors of the Federal Reserve System (U.S.).
  13. Garman, Mark B. & Kohlhagen, Steven W., 1983. "Foreign currency option values," Journal of International Money and Finance, Elsevier, Elsevier, vol. 2(3), pages 231-237, December.
  14. Flood, Robert P. & Rose, Andrew K. & Mathieson, Donald J., 1991. "An empirical exploration of exchange-rate target-zones," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 35(1), pages 7-65, January.
  15. Svensson, Lars E. O., 1991. "The term structure of interest rate differentials in a target zone : Theory and Swedish data," Journal of Monetary Economics, Elsevier, Elsevier, vol. 28(1), pages 87-116, August.
  16. Svensson, L.E.O., 1989. "Target Zones And Interest Rate Variability," Papers, Stockholm - International Economic Studies 457, Stockholm - International Economic Studies.
  17. Dumas, B. & Jennergren, L.P. & Naslund, B., 1993. "Siegel's Paradox and Pricing of Currency Options," Weiss Center Working Papers, Wharton School - Weiss Center for International Financial Research 93-8, Wharton School - Weiss Center for International Financial Research.
  18. Lindbecg, H. Soderlind, P., 1992. "Target Zone Models and the Intervention Policy; The Swedish Case," Papers, Stockholm - International Economic Studies 496, Stockholm - International Economic Studies.
  19. Bertola, Giuseppe & Svensson, Lars E O, 1993. "Stochastic Devaluation Risk and the Empirical Fit of Target-Zone Models," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 60(3), pages 689-712, July.
  20. Edison, Hali J. & Fisher, Eric O'N, 1991. "A long-run view of the European monetary system," Journal of International Money and Finance, Elsevier, Elsevier, vol. 10(1), pages 53-70, March.
  21. Geske, Robert, 1979. "The valuation of compound options," Journal of Financial Economics, Elsevier, Elsevier, vol. 7(1), pages 63-81, March.
  22. Bernard Dumas & L. Peter Jennergren & Bertil Naslund, 1993. "Currency Option Pricing in Credible Target Zones," NBER Working Papers 4522, National Bureau of Economic Research, Inc.
  23. Lindberg, H. & Soderlind, P., 1991. "Testing the Basic Target Zone Model on Swedish Data," Papers, Stockholm - International Economic Studies 488, Stockholm - International Economic Studies.
  24. Hans Lindberg & Lars E.O. Svensson & Paul Soderlind, 1991. "Devaluation Expectations: The Swedish Krona 1982-1991," NBER Working Papers 3918, National Bureau of Economic Research, Inc.
  25. Lars E. O. Svensson, 1992. "An Interpretation of Recent Research on Exchange Rate Target Zones," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 6(4), pages 119-144, Fall.
  26. Orlin J. Grabbe, . "The Pricing of Call and Put Options on Foreign Exchange," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 06-83, Wharton School Rodney L. White Center for Financial Research.
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Citations

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Cited by:
  1. Mordecai Avriel & Jens Hilscher & Alon Raviv, 2012. "Inflation Derivatives Under Inflation Target Regimes," Working Papers, Brandeis University, Department of Economics and International Businesss School 43, Brandeis University, Department of Economics and International Businesss School.
  2. Ekvall, Niklas & Peter Jennergren, L. & Naslund, Bertil, 1997. "Currency option pricing with mean reversion and uncovered interest parity: A revision of the Garman-Kohlhagen model," European Journal of Operational Research, Elsevier, Elsevier, vol. 100(1), pages 41-59, July.
  3. Bardhan, Indrajit, 1995. "Exchange rate shocks, currency options and the Siegel paradox," Journal of International Money and Finance, Elsevier, Elsevier, vol. 14(3), pages 441-458, June.
  4. Young-Kyu Moh, 2006. "Continuous-time model of uncovered interest parity with regulated jump-diffusion interest differential," Applied Economics, Taylor & Francis Journals, Taylor & Francis Journals, vol. 38(21), pages 2523-2533.
  5. Rangvid, Jesper & Sorensen, Carsten, 2001. "Determinants of the implied shadow exchange rates from a target zone," European Economic Review, Elsevier, Elsevier, vol. 45(9), pages 1665-1696, October.
  6. Naszódi, Anna, 2002. "A sávos árfolyamú deviza megközelítése opciók segítségével
    [The option-based description of the exchange rate in a target-zone system]
    ," Közgazdasági Szemle (Economic Review - monthly of the Hungarian Academy of Sciences), Közgazdasági Szemle Alapítvány (Economic Review Foundation), vol. 0(1), pages 25-44.
  7. Mundaca, Gabriela, 2003. "A Drift of the "Drift Adjustment Method"," Memorandum, Oslo University, Department of Economics 16/2002, Oslo University, Department of Economics.
  8. Lioui, Abraham, 1998. "Currency risk hedging: Futures vs. forward," Journal of Banking & Finance, Elsevier, Elsevier, vol. 22(1), pages 61-81, January.
  9. Dumas, B. & Jennergren, L.P. & Naslund, B., 1993. "Currency Option Pricing in Credible Target Zones," Weiss Center Working Papers, Wharton School - Weiss Center for International Financial Research 93-7, Wharton School - Weiss Center for International Financial Research.
  10. Rahel Studer-Suter & Alexandra Janssen, 2014. "The Swiss franc's honeymoon," ECON - Working Papers, Department of Economics - University of Zurich 170, Department of Economics - University of Zurich.
  11. Naszódi, Anna, 2004. "A sáveltolás árfolyamhatásának vizsgálata opciós modell keretei között
    [Target-zone rearrangement and exchange-rate behaviour in an options-based model]
    ," Közgazdasági Szemle (Economic Review - monthly of the Hungarian Academy of Sciences), Közgazdasági Szemle Alapítvány (Economic Review Foundation), vol. 0(7), pages 638-658.
  12. Christian Pierdzioch, 2000. "The Effectiveness of the FX Market Interventions of the Bundesbank During the Louvre Period: An Options-Based Analysis," Kiel Working Papers 971, Kiel Institute for the World Economy.

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