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Analogy Based Valuation of Currency Options

Hammad Siddiqi

No 198776, Risk and Sustainable Management Group Working Papers from University of Queensland, School of Economics

Abstract: The two most intriguing anomalies in currency markets are: 1) the implied volatility smile in currency options, and 2) the forward discount bias in currency exchange rates. I show that if currency options are valued in analogy with the underlying currency and beliefs are heterogeneous, then the forward discount bias causes the smile. The analogy based currency option pricing formula is put forward, which converges to Garman-Kohlhagen formula if there is no forward discount bias. In the presence of the forward discount bias, an increase in belief dispersion increases the slope as well as the curvature of the smile.

Keywords: Financial; Economics (search for similar items in EconPapers)
Pages: 21
Date: 2015-02
New Economics Papers: this item is included in nep-fmk
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Persistent link: https://EconPapers.repec.org/RePEc:ags:uqsers:198776

DOI: 10.22004/ag.econ.198776

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