DERIVATIVE PRICING BASED ON THE EXCHANGE RATE IN A TARGET ZONE WITH REALIGNMENT

Lijun Bo (), Yongjin Wang () and Xuewei Yang ()
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Lijun Bo: Department of Mathematics, Xidian University, Xi'an 710071, P. R. China
Yongjin Wang: School of Business, Nankai University, Tianjin 300071, P. R. China
Xuewei Yang: School of Mathematical Sciences, Nankai University, Tianjin 300071, P. R. China

International Journal of Theoretical and Applied Finance (IJTAF), 2011, vol. 14, issue 06, 945-956

Abstract: We propose a tractable model for the exchange rate in a target zone with realignment. The target zone exchange rate dynamics is assumed to obey a bounded regular diffusion with two-sided unattainable barriers. The realignment is modeled as a continuous-time two-state Markov chain. Under the stationary setting of the Markov chain, a general pricing formula for the derivative written on the exchange rate is derived in the presence of the realignment risk. The Jacobi diffusion model is studied as an example and numerical results are presented for illustration.

Keywords: Target zone exchange rate; currency derivative pricing; bounded diffusion; Markov chain; realignment; Jacobi diffusion (search for similar items in EconPapers)
Date: 2011
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Citations: View citations in EconPapers (1)

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DOI: 10.1142/S0219024911006796

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