FX Derivatives with Pre-Announced Peg: Emu Ins

Abstract

The chosen final convergence for EMU has been to pre-announce the target convergence rate of ERM central parity. This paper analyses some of the pricing and the arbitrage problems market participants had to face between the FX forward and Vanilla option books. We describe a methodology to price FX option when both a peg and the peg level have been pre-announced. We derive explicit pricing formula for FX options and show how--once a parity is announced--the FX dynamics has a stronger link with the interest rates dynamics than in the normal case.

JEL Classification: G13,G15,G18,F36,D84