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An equilibrium approach to pricing foreign currency options

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  • Carsten Sørensen

Abstract

The paper presents a modified version of the Garman‐Kohlhagen formula for pricing European currency options. The equilibrium approach deviates from the no‐arbitrage approach by allowing domestic and foreign interest rates and their dynamics to be determined endogenously in the model. By using the relations between exchange rate dynamics and the dynamics of interest rates, I provide a new characterisation of the relevant volatilities for European currency option pricing, which only depends on parameters describing the variability of the log‐exchange rate. The implications of the model for the valuation of American currency options and optimal exercise strategies are examined by applying numerical methods.

Suggested Citation

  • Carsten Sørensen, 1997. "An equilibrium approach to pricing foreign currency options," European Financial Management, European Financial Management Association, vol. 3(1), pages 63-84, March.
    • Handle: RePEc:bla:eufman:v:3:y:1997:i:1:p:63-84
    DOI: 10.1111/1468-036X.00031
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    Cited by:

    1. Andrés García Mirantes & Javier Población & Gregorio Serna, 2012. "The Stochastic Seasonal Behaviour of Natural Gas Prices," European Financial Management, European Financial Management Association, vol. 18(3), pages 410-443, June.
    2. Junkee Jeon & Geonwoo Kim, 2022. "Analytic Valuation Formula for American Strangle Option in the Mean-Reversion Environment," Mathematics, MDPI, vol. 10(15), pages 1-19, July.
    3. Wong, Hoi Ying & Lo, Yu Wai, 2009. "Option pricing with mean reversion and stochastic volatility," European Journal of Operational Research, Elsevier, vol. 197(1), pages 179-187, August.
    4. Jeon, Junkee & Kim, Geonwoo, 2022. "Pricing European continuous-installment currency options with mean-reversion," The North American Journal of Economics and Finance, Elsevier, vol. 59(C).
    5. Pierdzioch, Christian, 2000. "The Effectiveness of the FX Market Interventions of the Bundesbank During the Louvre Period: An Options-Based Analysis," Kiel Working Papers 971, Kiel Institute for the World Economy (IfW Kiel).

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