Pricing currency options in the presence of time-varying volatility and non-normalities |
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| Affiliation: | 1. Department of Economics, University of Melbourne, 3010 Vic., Australia;2. Department of Econometrics and Business Statistics, Monash University, Australia;1. University of Michigan – Dearborn, 19000 Hubbard Dr., Dearborn, MI 48126, United States;2. University of Ontario Institute of Technology, 2000 Simcoe Street North, Oshawa, Ontario L1H 7K4, Canada;1. Department of Economics, Curtin University, Perth, Australia;2. School of Economics, University of Wollongong, NSW 2552, Australia;1. Department of Finance, Chihlee Institute of Technology, No. 313, Section 1, Wunhua Road, Banciao District, New Taipei City 22050, Taiwan, ROC;2. Department of Finance, National Taiwan University, No. 1, Section 4, Roosevelt Road, Taipei 10617, Taiwan, ROC;1. Fundação Dom Cabral, Brazil;2. NYU Shanghai, Shanghai, China;3. Vienna University of Economics and Business, Austria |
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| Abstract: | A new framework is developed for pricing currency options in the case where the distribution of exchange rate returns exhibits time-varying volatility and non-normalities. A forward-looking volatility structure is adopted whereby volatility is expressed as a function of currency returns over the life of the contract. Time to maturity and moneyness effects in volatility are also modelled. An analytical solution for the option price is obtained up to a one-dimensional integral in the real plane, enabling option prices to be computed efficiently and accurately. The proposed modelling framework is applied to European currency call options for the UK pound written on the US dollar, over the period October 1997–June 1998. The results show that pricing higher order moments improves both within-sample fit and out-of-sample prediction of observed option prices, as well as having important implications for constructing hedged portfolios and managing risk. |
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