An exact pricing formula for European call options on zero-coupon bonds in the run-up to a currency union

In this paper we analyze the dynamics of zero-coupon bond options in a situation in which two open economies plan to enter a currency union in the future. More precisely, we make use of recent theoretical work on the continuous-time dynamics of interest-rate differentials between the economies invol...

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Bibliographic Details
Published inIDEAS Working Paper Series from RePEc
Main Authors Reher, Gerrit, Wilfling, Bernd
Format Paper
LanguageEnglish
Published St. Louis Federal Reserve Bank of St. Louis 01.01.2010
Subjects
Put & call options
Zero coupon bonds
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Summary:In this paper we analyze the dynamics of zero-coupon bond options in a situation in which two open economies plan to enter a currency union in the future. More precisely, we make use of recent theoretical work on the continuous-time dynamics of interest-rate differentials between the economies involved and derive a closed-form pricing formula for a European call option on zero-coupon bonds. In a Monte-Carlo simulation study we show that significant option-pricing errors can occur when the key features of interest-rate dynamics during the run-up to the currency union are ignored.