NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

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.

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Document Object Identifier (DOI): 10.3386/w4458

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

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