Siegel's paradox and the pricing of currency options

Article Abstract:

The efficacy of the classic jump-diffusion model for option pricing proposed by R. Merton is disputed on the basis of its violation of the law of one price. Its assumption that the jump risk is non-priced or can be diversified away fails when it comes to currency option pricing. Thus, currency option prices derived by using the model may show a slight difference, depending on whose perspective the computation was done, whether from that of the domestic or foreign investor.

Currency options

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Comment on 'Exchange rate shocks, currency options and the Siegel paradox' by Indrajit Bardhan

Article Abstract:

A study on foreign exchange rate fluctuations, currency options and the Siegel paradox on the relationship between current and future exchange rates is analyzed. It is shown that the Siegel paradox is the result of the absence of equilibrium in the financial market. The Merton (1976) model is also shown to be an inappropriate model of jump risk to disprove the claim that investors of two countries can hedge risks when jumps are predictable.

Analysis

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A nonlinear stochastic rational expectations model of exchange rates

Article Abstract:

A model of exchange rates determination is constructed using nonlinear stochastic rational expectations theory. This model was evaluated and found to be consistent with short term results in the foreign exchange market. The model takes into account the intervention and non-intervention of the Central Bank using a deterministic intervention rule. Process shifting is discussed. Mathematical analysis of the model is also presented.

Rational expectations (Economics)

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