Derivative Pricing Based on the Exchange Rate in a Target Zone with Realignment
International Journal of Theoretical and Applied Finance (IJTAF), Forthcoming
13 Pages Posted: 6 May 2011
Date Written: December 9, 2010
We propose a tractable model for the exchange rate in a target zone with realignment. The target zone exchange rate dynamics is assumed to obey a bounded regular diffusion with two-sided unattainable barriers. The realignment is modeled as a continuous-time two-state Markov chain. Under the stationary setting of the Markov chain, a general pricing formula for the derivative written on the exchange rate is derived in the presence of the realignment risk. The Jacobi diffusion model is studied as an example and numerical results are presented for illustration.
Keywords: Target zone exchange rate, currency derivative pricing, bounded diffusion, Markov chain, realignment, Jacobi diffusion
JEL Classification: C13, C15, F31
Suggested Citation: Suggested Citation