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Equilibrium Valuation of Foreign Exchange Claims

Authors

  • GURDIP S. BAKSHI,

  • ZHIWU CHEN

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    • Bakshi is from the University of Maryland, and Chen is from the Ohio State University. We thank David Backus, Suleyman Basak, Glenn Boyle, Charles Cao, Jia He, Jimmy Hilliard, Louis Scott, and especially René Stulz (the editor) and the referee for helpful comments and suggestions. We also gratefully acknowledge comments by seminar participants at the University of Georgia, Louisiana State University, University of New Orleans, and Tulane University. Any remaining errors are the authors' alone.


ABSTRACT

This article studies the equilibrium valuation of foreign exchange contingent claims. Within a continuous-time Lucas (1982) two-country model, exchange rates, interest rates and, in particular, factor risk prices are all endogenously and jointly determined. This guarantees the internal consistency of these price processes with a general equilibrium. In the same model, closed-form valuation formulas are presented for currency options and currency futures options. Common to these formulas is that stochastic volatility and stochastic interest rates are admitted. Hedge ratios and other comparative statics are also provided analytically. It is shown that most existing currency option models are included as special cases.

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