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Risk-minimizing pricing and hedging foreign currency options under regime-switching jump-diffusion models

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  • Shaoyong Hu
  • Ailin Zhu

Abstract

This article mainly investigates risk-minimizing European currency option pricing and hedging strategy when the spot foreign exchange rate is driven by a Markov-modulated jump-diffusion model. We suppose the domestic and foreign money market floating interest rates, the drift, and the volatility of the exchange rate dynamics all depend on the state of the economy, which is modeled by a continuous-time hidden Markov chain. The model considered in this article will provide market practitioners with flexibility in characterizing the dynamics of the spot foreign exchange rate. Using the minimal martingale measure, we obtain a system of coupled partial-differential-integral equations satisfied by the currency option price and find the corresponding hedging strategies and the residual risk. According to simulation of currency option prices in the special case of double exponential jump-diffusion regime-switching model, we further discuss and show the effects of the parameters on the prices.

Suggested Citation

  • Shaoyong Hu & Ailin Zhu, 2017. "Risk-minimizing pricing and hedging foreign currency options under regime-switching jump-diffusion models," Communications in Statistics - Theory and Methods, Taylor & Francis Journals, vol. 46(4), pages 1821-1842, February.
    • Handle: RePEc:taf:lstaxx:v:46:y:2017:i:4:p:1821-1842
    DOI: 10.1080/03610926.2015.1030420
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    Cited by:

    1. Jun Wei, 2020. "Optimal Combination of Currency Assets and Algorithm Simulation under Exchange Rate Risk," Complexity, Hindawi, vol. 2020, pages 1-10, November.
    2. 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).

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