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DERIVATIVE PRICING BASED ON THE EXCHANGE RATE IN A TARGET ZONE WITH REALIGNMENT

LIJUN BO

Department of Mathematics, Xidian University, Xi'an 710071, P. R. China

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YONGJIN WANG

School of Business, Nankai University, Tianjin 300071, P. R. China

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, and

XUEWEI YANG

School of Mathematical Sciences, Nankai University, Tianjin 300071, P. R. China

Corresponding author.

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https://doi.org/10.1142/S0219024911006796Cited by:4 (Source: Crossref)

Abstract

We propose a tractable model for the exchange rate in a target zone with realignment. The target zone exchange rate dynamics is assumed to obey a bounded regular diffusion with two-sided unattainable barriers. The realignment is modeled as a continuous-time two-state Markov chain. Under the stationary setting of the Markov chain, a general pricing formula for the derivative written on the exchange rate is derived in the presence of the realignment risk. The Jacobi diffusion model is studied as an example and numerical results are presented for illustration.

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