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Currency option pricing in a credible exchange rate target zone

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  • Dirk Veestraeten

Abstract

This article examines currency option pricing within a credible target zone arrangement where interventions at the boundaries push the exchange rate back into its fluctuation band. Valuation of such options is complicated by the requirement that the reflection mechanism should prevent the arbitrage opportunities that would arise if the exchange rate were to spend finite time on the boundaries. To prevent the latter, we superimpose instantaneously reflecting boundaries upon the familiar geometric Brownian motion (GBM) framework. We derive closed-form expressions for European call and put option prices and show that prices for the GBM model of Garman and Kohlhagen (1983) arise as the limit case for infinitely wide bands. We also illustrate that taking account of boundaries is of considerable economic value as erroneously using the unbounded-domain model of Garman and Kohlhagen (1983) easily overprices options by more than 100%.

Suggested Citation

  • Dirk Veestraeten, 2013. "Currency option pricing in a credible exchange rate target zone," Applied Financial Economics, Taylor & Francis Journals, vol. 23(11), pages 951-962, June.
    • Handle: RePEc:taf:apfiec:v:23:y:2013:i:11:p:951-962
    DOI: 10.1080/09603107.2013.778945
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    Cited by:

    1. Taiga Saito, 2016. "Pricing Foreign Exchange Options Under Intervention by Absorption Modeling," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 23(1), pages 85-106, March.
    2. Dean Buckner & Kevin Dowd & Hardy Hulley, 2022. "Arbitrage Problems with Reflected Geometric Brownian Motion," Papers 2201.05312, arXiv.org, revised Sep 2022.
    3. Alexandra Janssen & Rahel Studer, 2014. "The Swiss franc's honeymoon," ECON - Working Papers 170, Department of Economics - University of Zurich, revised Jan 2017.
    4. Markus Hertrich & Heinz Zimmermann, 2017. "On the Credibility of the Euro/Swiss Franc Floor: A Financial Market Perspective," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 49(2-3), pages 567-578, March.
    5. Hertrich Markus, 2016. "The Costs of Implementing a Unilateral One-Sided Exchange Rate Target Zone," Review of Economics, De Gruyter, vol. 67(1), pages 91-120, May.
    6. Markus Hertrich, 2015. "A Cautionary Note on the Put-Call Parity under an Asset Pricing Model with a Lower Reflecting Barrier," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 151(III), pages 227-260, September.

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