Stochastic Interest Rates and Short Maturity Currency Options

Abstract

This paper uses a ten-year data set to examine the ability of the jump-diffusion models to explain systematic deviations in implicit distributions from the benchmark assumption of lognormality. Scott's (1997) calibrations found that stochastic interest rates should not affect short-maturity stock option prices much. Using transactions data from the Philadelphia stock exchange (PHLX) for European call and put currency options on the Deutschmark, the Japanese yen and sterling, over the period July 1984 to August 1989 and from March 1995 to December 1999, this study provides a robust proof that stochastic interest rates do affect short-maturity currency options. The results are consistent with and incremental to Doffou and Hilliard (2002).

Keywords: Stochastic Interest Rates, Currency Options, Lognormality, Volatility Smile, Jump-Diffusion Models

JEL Classification: G12, C52, C63