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The purpose of this paper is to derive closed-form formulas for a European currency call
option and a put counterpart, respectively, and to discuss the properties of these options. But
we are studying only the derivation part. It follows the risk-neutral approach (Cox and Ross,
1976) by exploring equilibrium conditions among a spot exchange rate, a forward exchange
rate, and the interest rate differential between two countries. It shows that a direct application
of the Black-Scholes (B-S) model (1973) to currency options is not feasible because of an
equilibrium condition prevailing among a domestic risk-free interest rate, a foreign risk-free
interest rate and the movement of a spot exchange rate. Rather, the option pricing model
considering dividend payments (a continuous, constant dividend yield) by Merton (1973) can
be applied to currency options.

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@nder the following assumptions, the current value of a European currency call option (C) at
the exercise price of X with a time to maturity of IJ = (T - t) is the discounted expected
terminal value of C:

C = e-k IJ E{C (T)}


= e-kIJ 
    
 
  (1)

Where k is an appropriate instantaneous discount factor (expected growth rate of the option
price), S denotes a spot exchange rate expressed in units of domestic currency per unit of
foreign currency. Note that L (‡) is a lognormal density function.
O




   




1.p Uoreign exchange rates (spot exchange rates, S and forward exchange rates, U) follow
a geometric Brownian motion. Thus, these prices satisfy respectively the following
stochastic differential equations:

dS/S=µs dt +ıs dzs

dU/U=µU dt +ıU dzU (2)

Where µs is a deterministic function of S and t, ıs is a positive constant and dz,

denotes the differential of the standard Gauss-Wiener process with the properties of
E(dzs) = 0 and Var (dzs) = dt. µU, ıU and dzU have similar definitions, respectively.

2.p Uoreign exchange markets are frictionless and provide continuous trading
opportunities. As a result, the interest rate parity theorem holds, which is given by ;
3.p


U (t, T) = S (t) ; (3)

Where r and r1 are an instantaneous domestic risk free interest rate and a foreign
counterpart, respectively. Also, it is assumed that U (t, T)pis an unbiased estimator of
S(T);

U (t, T) = E{S(T)} (4)

4.p r and r1 are non-stochastic for the time to maturity of a currency option.
Uollowing the B-S hedging portfolio construction, a portfolio (H)pis formed as;

H = CsS ± C (5)

By Itô lemma,

dC = Cs dS + Ct dt + 1/2 Css ıs S2 dt (6)

The change in the value of H should consider availability of additional income from
investment in S since it can be carried out by holding a risk-free foreign bond. Therefore,
there are three sources of change in the value of H, dS, dC and r1Sdt. The change in the value
of H is given by:

dH = Cs(dS + r1Sdt) ± dC (7)

Substituting (6) into (7) yields

dH = Cs r1 Sdt - Ct dt ± 1/2 Css S2 ıs dt (8)

Which is non-stochastic. The inclusion of the yield on a risk-free foreign bond in the rate of
return on H is necessary because the expected return from investing in S is the sum of the
drift of S and the riskless capital growth at the rate of r1 (Garman and Kohlagen, 1983).

Since perfect substitution must earn the same rate of return in efficient capital markets, the
risk-free hedge portfolio, H, must earn the domestic risk free rate, r in equilibrium. Thus,

dH/H = r dt (9)

Substituting (5) and (8) into (9) yields a partial differential equation for the value of C,
 C = r C + (r1 - r) Cs - 1/2Css ıs S2 (10)

The value of a European currency call option is a solution to equation (10) together with the
boundary condition,

C(T) = Max (0 , S(T) - X)

Note that equation (10) is the same as the partial differential equation derived by Merton
(1973) for an option on a stock with proportional dividends. Thus the closed-form formulas
can be followed as reported in equation (14).

Alternatively, since the solution of equation (10) does not need to consider the instantaneous
expected rate of return on S, µs, the value of C does not depend on the underlying preference
structure of investors. Therefore, the value of C should be the same under any attitude of
investors toward risk (Cox and Ross, 1976). Once investors are assumed to be risk-neutral, in
equilibrium, the appropriate discount rate, k, in equation (1) should be equal to r.
Uurthermore, r should be equal to the sum of r1 and P, where P is the expected growth rate in
spot exchange rates given by:

PIJ = ln E{S (T)/S (t)} (11)

Urom (3), (4) and (11),

PIJ = ln{U(t, T)/S(t)} = (r-r1)IJ (12)

Thus, P = r ±r1, which states that the expected growth rate in spot exchange rates is the
difference between the domestic risk free interest rate and the foreign counterpart.
Consequently, there is a relationship given by:

r = k = r1 + P (13)
In this context, Smith (1976) shows a way to obtain the closed-form formula for C, which is
given by:

C = ;  S N (d1) ± ;  X N (d2) (14)

Where,


     !

d1 = "

d2 = d1 ± ıs ¥IJ

Value of corresponding Put option can be calculated by replacing d1 and d2 by (-d1 ) and (-d2)
in equation (14).

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This study develops a currency option pricing model under stochastic interest rates when
interest rate parity holds, and it is assumed that domestic and foreign bond prices have local
variances that depend only on time.

European options on the spot and on futures have identical prices when the option and futures
contracts expire simultaneously. This result is obvious when one considers that the spot and
futures prices are identical at contract expiration and that early exercise is prohibited when
the option is European. @sing this result, we show that pricing European currency options is
particularly straightforward under stochastic interest rates when interest rate parity holds, and
it is assumed that domestic and foreign bond prices have local variances that depend only on
time and not on other state variables such as the level of short-term interest rates.

The pricing model developed in this study is closely related to Black's (1976) futures option
pricing model except that the variance component in the Black formulation, ı2IJ, is replaced

by an integral of the form $ # 
 , where IJ is the time to expiration of the option and ı2(s)
depends on the form of the bond pricing model assumed.

Notation

The following notation is employed:

S (t) = the spot exchange rate;

U (t, T) = the forward exchange rate at time t for settlement at T;
B1 (t, T) = the domestic currency price of a bond with maturity T and unit face value;
B2 (t, T) = the foreign currency price of a bond with maturity T and unit face value;
C (t, T) = the price of a European call option with exercise price K;
r (t) = the instantaneous domestic (@.S.) short rate of interest; and
f (t) = the instantaneous foreign short rate of interest.
Assumptions and Relations

The following assumptions and relations are used:

(1) U (t, T) = S (t) B2 (t, T)/B1 (t, T); (interest rate parity)
(2) dS/S = µs (t) dt + ıs dZs; (spot exchange rate process)
(3) dB1 / B1 = µ1 ‡ dt + ı1(t, T)dZ1; (domestic bond process)
(4) dB2/ B2 = µ2 ‡ dt + ı2( t, T)dZ2; (foreign bond process)
(5) dr = Į (r, t)dt + ı r dZr; (domestic short rate process)
(5a) df = Į (f, t)dt + ı f dZf; (foreign short rate process)

Derivation

Our derivation assumes frictionless markets and utilizes the risk-neutrality principle of Cox
and Ross (1976). Uirst, following Grabbe (1983), we show that a risk-free hedge is locally
possible. Uurthermore, Ueiger and Jacquillat (1979) have shown that these portfolios are self-
financing. Since preference-free pricing holds, it follows that the European call option values
can be computed by discounting expected cash flows from the option by the domestic bond
rate.

As in Grabbe, let G = SB2 and express the currency call option as C = C (G, B1, t). Uorm a
portfolio V composed of G, B1, and C. Specifically, let

(6) V = C + YB1 + ĮG,

` `
Where Y = -`
 and Į = - ` , giving

` `
(6a) V=C- B1 - G,
`
 `

Merton (1973) has shown that call prices are homogeneous in G and B1 in an isomorphic
problem. Homogeneity is sufficient for Euler's theorem which, together with Equation (6),
assures us that V = 0. Uurthermore, since V requires no initial investment and dV has no
stochastic components, we conclude that dV = 0. @sing this result and applying Ito's lemma
to Equation (6) gives
  ` ` ` `
(7) [ B 2ı 2 +
 1 B1
G2ıG2 + 2 Corr (dG, dB1)] - =0
`
 `  `
` `

Where IJ = T - t and dG = (‡)dt + G(ıs dZs + ı2(t, T)dZ2 ). Equation (7) is identical to the
stochastic interest rate equations derived by Merton (1973), the exchange option model of
Margrabe (1978), and the currency option models of Grabbe (1983) and Ueiger and Jacquillat
(1979). Since pricing Equation (7) is independent of preferences and the option is European,
its solution can be obtained by invoking the risk-neutrality principle of Cox and Ross. Uor
European calls, the boundary condition is max [0, ST - K] = max [0, UT ²K], so that the
equilibrium price of the call is

(8) C (t, T, U) = B1 (t, T) ӂ [max {0, UT - K}],

Where ӂ is the expectation operator over the risk-neutralized random variable U.