Pricing Foreign Exchange Options Under Intervention by Absorption Modeling

Taiga Saito ()
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Taiga Saito: Financial Research Center at Financial Services Agency

Asia-Pacific Financial Markets, 2016, vol. 23, issue 1, No 4, 85-106

Abstract: Abstract We consider option pricing for a foreign exchange (FX) rate where interventions by an authority may take place when the rate approaches to a certain level at the down side. We formulate the forward FX model by a diffusion process which is stopped by a hitting time of an absorption boundary. Moreover, for a deterministic volatility case with a moving absorption whose level is described by an ordinary differential equation, we obtain closed-form formulas for prices of a European put option and a digital option, and Greeks of the put option. Furthermore, we show an extension of the pricing formula to the case where the intervention level is unknown. In numerical examples, we show option prices for different strikes for the absorption model and the extended model. We compare the model prices with the market prices for EURCHF options traded before January 2015 with the absorption model, and also show experiments of the extended model as an application to the pricing under uncertain views on the intervention.

Keywords: Intervention; Options; Foreign exchange; Absorption; 60H10 (search for similar items in EconPapers)
JEL-codes: G13 G15 (search for similar items in EconPapers)
Date: 2016
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DOI: 10.1007/s10690-016-9210-1

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