Equilibrium Valuation of Foreign Exchange Claims
This paper studies the equilibrium valuation of foreign exchange-contingent claims. The basic framework is the continuous-time counterpart of the classic Lucas (1982) two-country model, in which exchange rates, term structures of interest rates and, in particular, factor risk prices are all endogenously determined and empirically plausible. This endogenous nature guarantees the internal consistency of these price processes with a general equilibrium. In addition to the domestic and foreign nominal interest rates, closed-form valuation formulas are presented for exchange rate options and exchange rate futures options. Common to these formulas is that stochastic volatility and stochastic interest rates are admitted. Hedge ratios and other comparative statics are provided analytically. It is shown that most existing currency option models are included as special cases.
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