The Journal of Finance

Equilibrium Valuation of Foreign Exchange Claims

Published: 04/18/2012   |   DOI: 10.1111/j.1540-6261.1997.tb04822.x

GURDIP S. BAKSHI, ZHIWU CHEN

This article studies the equilibrium valuation of foreign exchange contingent claims. Within a continuous‐time Lucas (1982) two‐country model, exchange rates, interest rates and, in particular, factor risk prices are all endogenously and jointly determined. This guarantees the internal consistency of these price processes with a general equilibrium. In the same model, closed‐form valuation formulas are presented for currency options and currency futures options. Common to these formulas is that stochastic volatility and stochastic interest rates are admitted. Hedge ratios and other comparative statics are also provided analytically. It is shown that most existing currency option models are included as special cases.

Empirical Performance of Alternative Option Pricing Models

Published: 04/18/2012   |   DOI: 10.1111/j.1540-6261.1997.tb02749.x

Gurdip Bakshi, Charles Cao, Zhiwu Chen

Substantial progress has been made in developing more realistic option pricing models. Empirically, however, it is not known whether and by how much each generalization improves option pricing and hedging. We fill this gap by first deriving an option model that allows volatility, interest rates and jumps to be stochastic. Using S&P 500 options, we examine several alternative models from three perspectives: (1) internal consistency of implied parameters/volatility with relevant time‐series data, (2) out‐of‐sample pricing, and (3) hedging. Overall, incorporating stochastic volatility and jumps is important for pricing and internal consistency. But for hedging, modeling stochastic volatility alone yields the best performance.