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Valuation and empirical analysis of currency options

Ming-Che Chuang, Chin-Hsiang Wen and Shih-Kuei Lin

International Review of Economics & Finance, 2020, vol. 66, issue C, 71-91

Abstract: In this paper, we study whether the correlated jump risks of interest and exchange rates play an important role in currency option pricing. We augment the model of Jarrow and Yildirim (2003) with correlated jump risks (herein referred to as the CB-CJ model) and derive the pricing formula for currency options under this model. Using the data of the United States, Japan, European Union, and the United Kingdom, we find that CB-CJ outperforms the geometric Brownian model, the original Jarrow and Yildirim model, and the Jarrow and Yildirim model with independent jump risks because it substantially improves the in-sample and out-of-sample pricing errors in most cases. As a result, we conclude that correlated jump risks are important factors when pricing currency options.

Keywords: Exchange rate; Interest rate; Currency option; Jarrow and yildirim model; Jump risks; Correlated jump risks (search for similar items in EconPapers)
JEL-codes: G01 G13 (search for similar items in EconPapers)
Date: 2020
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DOI: 10.1016/j.iref.2019.10.013

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