| Exchange rate fluctuations combined with the growth in volume of world trade over the last decade, have resulted in an increase in the demand for foreign currency options, futures and forward contracts. This research is concerned with the valuation of such contracts and the arbitrage relationships among them.; The study shows that the price behavior of currency options depends upon the term structure of interest rates. The model developed is a hybrid between classical option pricing theory, and the intertemporal term structure of interest rates theory. A closed form solution is provided and is used to examine the effects of domestic and foreign yield curves on call option values. The empirical tests show that the proposed model performs better than existing ones, reduce the prediction errors with respect to the yield to maturity and exchange rate volatility.; In investigating the arbitrage relationships among the various markets, the same differential equation which is developed to find the theoretical value of the foreign currency option is used to obtain the value of the forward and futures contracts, the henceforth to draw some propositions. An econometric model is then suggested to compare the hedging effectiveness of the three contracts.; The study also addresses the functional form of exchange rate volatility. A new method for jointly estimating the parameters of the class of constant elasticity of variance is developed, and is applied to the valuation of foreign currency options. This method uses a derivative-free non-linear regression employing the Cranck-Nickolson finite difference method. The results indicate that the elasticity of variance is non-stationary, usually less than one, and appear to be different for different currencies. It is also shown that prediction errors with respect to time to maturity, options in (out)-of-the-money, and future volatility of exchange rate are considerably reduced. |
