Pricing European Currency Options: A Comparison of the Modified Black- Scholes Model and a Random Variance Model

Marc Chesney; Louis O. Scott

doi:10.2307/2330812

September 1, 1989Journal of Financial and Quantitative Analysis

Pricing European Currency Options: A Comparison of the Modified Black- Scholes Model and a Random Variance Model

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Key Points

To compare the theoretical and empirical pricing performance of the modified Black-Scholes model against a continuous-time random variance model for European currency options.
Formulated option pricing solutions using both a modified Black-Scholes framework with constant volatility and an alternative model incorporating stochastic volatility.
Estimated parameters from historical foreign currency exchange rates and evaluated model valuation errors across varying strike prices and maturities.
The random variance model accounts for leptokurtosis and volatility smile effects observed in empirical exchange rate distributions that constant volatility models fail to capture.
Stochastic variance specifications significantly reduce systematic mispricing for deep in-the-money and deep out-of-the-money European currency contracts.

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Implication

Comparative modeling study demonstrates reduced pricing errors in European currency options, highlighting the importance of stochastic volatility.

Abstract

Marc Chesney, Louis Scott, Pricing European Currency Options: A Comparison of the Modified Black- Scholes Model and a Random Variance Model, The Journal of Financial and Quantitative Analysis, Vol. 24, No. 3 (Sep., 1989), pp. 267-284

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Chesney et al. (1989) studied this question.

synapsesocial.com/papers/6a1b2a31813d829642967b0f https://doi.org/10.2307/2330812

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Pricing European Currency Options: A Comparison of the Modified Black- Scholes Model and a Random Variance Model

Key Points

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Cite This Study

Pricing European Currency Options: A Comparison of the Modified Black- Scholes Model and a Random Variance Model

Key Points

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Implication

Abstract

Discussion

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