An exact pricing formula for European call options on zero-coupon bonds in the run-up to a currency union
Reher Gerrit, Wilfling Bernd
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