An exact pricing formula for European call options on zero-coupon bonds in the run-up to a currency union
Abstract
In this paper we analyze the dynamics of zero-coupon bond options in a situation in which two open economies plan to enter a currency union in the future. To this end we make use of recent theoretical work on the continuous-time dynamics of interest-rate differentials between the economies involved and derive a closed-form pricing formula for a European call option on zero-coupon bonds. In a Monte-Carlo simulation study we show that significant option-pricing errors can occur when the key features of interest-rate dynamics during the run-up to the currency union are ignored.
Keywords
Exchange-rate dynamics; uncovered interest-rate parity; valuation of interest-rate options; currency union
Cite as
Reher, G., & Wilfling, B. (2010). An exact pricing formula for European call options on zero-coupon bonds in the run-up to a currency union. In CQE Working Paper: Vol. 10/2010. University of Muenster: Center for Quantitative Economics (CQE), University of Muenster.Details
Publication type
Working paper
Peer reviewed
No
Publication status
Published
Year
2010
Volume
10/2010
Title of series
CQE Working Paper
Publisher
Center for Quantitative Economics (CQE), University of Muenster
Place
University of Muenster
Language
English
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