Equilibrium Valuation of Foreign Exchange Claims
Gurdip S. Bakshi and Zhiwu Chen
August 8, 1995
Department of Economics and Finance, College of Business Administration, University of New Orleans, LA
70148, Tel: (504)-286-6096, email: gsbef@uno.edu; and Department of Finance, College of Business, Ohio State
University, 1775 College Road, Columbus, OH 43210, Tel: 614-688-4107, email: chen@cob.ohio-state.edu.
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Equilibrium Valuation of Foreign Exchange Claims
Abstract
Existing foreign exchange derivatives models share two main features. First, they are partial
equilibrium models that are built on exogenously assumed exchange rate, interest rates and
factor premium processes. Second, they are models of real economy, not nominal or monetary
economy. The partial equilibriumfeature provides no guarantee of internal consistency with any
general equilibrium, and the real economy feature is at odds with the fact that if any economic
variable has much to do with monetary policy, exchange rates must be on the top list. The
classic Lucas (1982) two-country monetary model is extended here to derive, endogenously and
in closed-form, the domestic and foreign nominal interest rates, the spot, forward and futures
(nominal) exchange rates, and foreign exchange option prices. Conditions under which existing
currency option models can be supported by the two-country monetary equilibriumare studied,
and a general currency option model is also developed that includes existing currency option
models as special cases.
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1 Introduction
Existing models for the valuation of foreign exchange derivatives are mostly based on the arbi-
trage/partial equilibrium approach. See, for a partial list, Amin and Jarrow (1991), Bates (1995),
Biger and Hull (1983), Chesney and Scott (1989), Garman and Kohlhagen (1983), Grabbe (1983),
Heston (1993), Ingersoll (1990), Knoch (1992), and Melino and Turnbull (1990, 1991). Typically,
these authors rst specify some exogenous processes for the spot exchange rate, the factor risk
premium, and the domestic and