Abstract
This paper extends the Heath, Jarrow and Morton model (1992) to atwo country setup. In the presence of common shocks and country specificshocks, we retrieve each country's pricing kernel implied by itsterm structure dynamics and show that the pricing kernels impose a constrainton the exchange rate to be the ratio of the pricing kernels. Under therisk neutral measure, the drift of the exchange rate is the interest ratedifferential, and the volatility reflects the forward rate risk-premiumdifferential of the two countries. The result implies that the risk premiumwill enter the currency option pricing model through the volatility term.Under the assumption of non-stochastic forward rate drift and volatility,we are able to derive closed-form solutions for currency options.
Similar content being viewed by others
References
Adams, D. and S. Wyatt. (1987). “Biases in Option Prices: Evidence fromthe Foreign Currency OptionMarket,” Journal of Banking and Finance 11, 549¶562.
Ahn, D. (1999). “Common Factors and Local Factors: Implications forTerm Structures and Exchange Rates,” forthcoming, Journal of Financial and Quantitative Analysis.
Amin, K. and J. Bodurtha, Jr. (1995). “Discrete-TimeValuation of American Options with Stochastic Interest Rates,” Review of Financial Studies 8, 193¶234.
Amin, K. and R. Jarrow. (1991). “Pricing Foreign Currency OptionsUnder Stochastic Interest Rate,” Journal of International Money and Finance 10, 310¶329.
Amin, K., and R. Jarrow. (1992). “Pricing Options on RiskyAssets in a Stochastic Interest Rate Economy, “Mathematical Finance 2, 217¶237.
Black, F. and M. Sholes. (1973). “The Pricing of Options and Corporate Liabilities,” Journal of Political Economy 81, 637¶659.
Bodurtha, J. and G. Courtadon. (1987). “Tests of an American Option Pricing Model on the Foreign Currency Market,” Journal of Financial and Quantitative Studies 22, 153¶167.
Chang, C. W. and J. S. K. Chang. (1990). “Forward and Futures Prices: Evidence from the Foreign Exchange Market,” Journal of Finance 45, 1333¶1336.
Cornell, B. and M. Reiganum. (1981). “Forward and Futures Prices: Evidence from the Foreign Exchange Market,” Journal of Finance 36, 1035¶1045.
Feiger, G. and B. Jacquillat. (1979). “Currency Option Bonds, Puts and Calls on Spot Exchange and the Hedging of Contingent Foreign Earnings,” Journal of Finance 5, 1129¶1139.
Garman, M. B. and S. W. Kohlhagen. (1983). “Foreign Currency Option Values,” Journal of International Money and Finance 2, 231¶237.
Grabbe, J. (1983). “The Pricing of Call and Put Options on Foreign Exchange,” Journal of International Money and Finance 5, 349¶359.
Harrison, J. and D. Kreps. (1979). “Martingales and Arbitrage in Multiperiod Security Markets,” Journal of Economic Theory 20, 381¶408.
Harrison, J. and S. Pliska. (1981). “Martingales and Stochastic Integrals in the Theory of Continuous Trading,” Stochastic Processes Applied 11, 215¶260.
Heath, D. C., R. Jarrow, and A. Morton. (1992). “Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation,” Econometrica 60, 77¶105.
Melino, A. and S. Turnbull. (1990). “Pricing Foreign Currency Options with Stochastic Volatility,” Journal of Econometrics 45, 239¶265.
Melino, A. and S. Turnbull. (1991). “The Pricing Foreign Currency Options,” Canadian Journal of Economics 26, 251¶281.
Merton, R. (1973). “The Theory of Rational Option Pricing,” Bell Journal of Economics and Management Science 4, 141¶183.
Nielson, L. and J. Saá-Requejo. (1993). “Exchange Rate and Term Structure Dynamics and the Pricing of Derivative Securities,” Journal of Finance 48, 1112¶1113 (Abstract).
Saá-Requejo, J. (1993). “The Dynamics and the Term Structure of Risk Premia in Foreign Exchange Markets,” Working Paper, INSEAD.
Shastri, K. and K. Tandon. (1986). “On the Use of European Models to Price American Options on Foreign Currency,” Journal of Financial and Quantitative Analysis 21,145¶160.
Author information
Authors and Affiliations
Rights and permissions
About this article
Cite this article
Ahn, DH., Gao, B. Locally Complete Markets, Exchange Rates and Currency Options. Review of Derivatives Research 6, 5–26 (2003). https://doi.org/10.1023/A:1022869920134
Issue Date:
DOI: https://doi.org/10.1023/A:1022869920134