In this article, the authors derive explicit formulas for European foreign exchange (FX) call and put option values when the exchange rate dynamics are governed by jump-diffusion processes. The authors use a simple general equilibrium international asset pricing model with continuous trading and frictionless international capital markets. The domestic and foreign price level are introduced as state variables that contain jumps caused by monetary shocks and catastrophic events such as 9/11 or Hurricane Katrina. The domestic and foreign interest rates are stochastic and endogenously determined in the model and are shown to be critically affected by the jump risk of the foreign exchange. The model shows thatWe would like to thank a referee and the editor for their valuable comments.1 Cox and Ross (1976) and Jones (1984) have derived option pricing formula by assuming deterministic jump amplitudes. 2 A stock option formula under jump-diffusion processes has been derived by Merton (1976). the behavior of FX options is affected through the impact of state variables and parameters on the nominal interest rates. The model contrasts with those of M. Garman and S. Kohlhagen (1983) andO. Grabbe (1983), whose models have exogenously determined interest rates.
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