Realignment Risk and Currency Option Pricing in Target Zones

Bernard Dumas, L. Peter Jennergren, Bertil Naslund

NBER Working Paper No. 4458
Issued in September 1993
NBER Program(s):   AP   IFM

This paper extends the Krugman target zone model by including a realignment mechanism. Various properties of that realignment mechanism are discussed. The movement of the exchange rate is governed both by a Wiener process on fundamental and by a Poisson jump process with endogenous realignment size. The realignment mechanism is such that (except in cases where a speculative attack occurs) no jump in fundamental is needed to accompany the jump in the exchange rate. A risk neutral valuation of currency options is constructed. Some properties of option values under realignment risk are illustrated by numerical results.

(2358 K)

(234 K)

Published: European Economic Review, Vol. 39, (1995), pp. 1523-1566.

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