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

See all articles by Xuewei Yang

Xuewei Yang

Nanjing University - School of Management and Engineering; Nanjing University - Institute of New Finance

Lijun Bo

University of Science and Technology of China (USTC)

Yongjin Wang

Nankai University - Business School

Date Written: December 9, 2010

Abstract

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

Yang, Xuewei and Bo, Lijun and Wang, Yongjin, Derivative Pricing Based on the Exchange Rate in a Target Zone with Realignment (December 9, 2010). International Journal of Theoretical and Applied Finance (IJTAF), Forthcoming , Available at SSRN: https://ssrn.com/abstract=1831643

Xuewei Yang (Contact Author)

Nanjing University - School of Management and Engineering ( email )

22 Hankou Road, Gulou District
Nanjing, Jiangsu 210093
China

Nanjing University - Institute of New Finance ( email )

Nanjing, Jiangsu 210093
China

Lijun Bo

University of Science and Technology of China (USTC) ( email )

96, Jinzhai Road
Hefei, Anhui 230026
China

Yongjin Wang

Nankai University - Business School ( email )

94 Weijin Road, Nankai District
Tianjin, 300071
China

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