The valuation of European call options on zero-coupon bonds in the run-up to a fixed exchange-rate regime

Reher Gerrit, Wilfling, Bernd

Abstract
We analyze the dynamics of zero-coupon bond options in a situation in which the currently floating exchange rate between two countries' currencies is announced to be fixed on a given future date. To this end, we combine two strands of research that have been treated as separate issues up to date. In particular, we make use of recent theoretical work on continuous-time dynamics of exchange rates and interest-rate differentials between the economies involved (as provided by the international-economics literature) and derive a closed-form pricing formula for a European call option on zero-coupon bonds (by means established in the classical finance literature). 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 fixed exchange-rate regime are ignored.

Keywords
Exchange-rate dynamics; uncovered interest parity; interest-rate options; switching exchange-rate regimes