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The valuation of European call options on zero-coupon bonds in the run-up to a fixed exchange-rate regime

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  • Reher, Gerrit
  • Wilfling, Bernd

Abstract

We analyze the dynamics of zero-coupon bond options in a situation in which the currently floating exchange rate between two countries' currencies is announced to be fixed on a given future date. To this end, we combine two strands of research that have been treated as separate issues up to date. In particular, we make use of recent theoretical work on continuous-time dynamics of exchange rates and interest-rate differentials between the economies involved (as provided by the international-economics literature) and derive a closed-form pricing formula for a European call option on zero-coupon bonds (by means established in the classical finance literature). 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 fixed exchange-rate regime are ignored.

Suggested Citation

  • Reher, Gerrit & Wilfling, Bernd, 2014. "The valuation of European call options on zero-coupon bonds in the run-up to a fixed exchange-rate regime," International Review of Economics & Finance, Elsevier, vol. 29(C), pages 483-496.
  • Handle: RePEc:eee:reveco:v:29:y:2014:i:c:p:483-496
    DOI: 10.1016/j.iref.2013.07.011
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    References listed on IDEAS

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    More about this item

    Keywords

    Exchange-rate dynamics; Uncovered interest parity; Interest-rate options; Switching exchange-rate regimes;

    JEL classification:

    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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