# Pricing Foreign Exchange Options

Incorporating Purchasing Power Parity (Second edition)

Publication Year: 1992

Published by: Hong Kong University Press, HKU

#### FOREWORD BY STEVEN N.S. CHEUNG

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p. v-v

Reading this book reminds me of that glad morning thirty years ago, when a coterie of young lions under Armen Alchian and Jack Hirshleifer was hard at work, laying the foundations of finance. Bill Sharpe invented CAPM (for which he was awarded the Nobel Prize the year before last), while I can still remember the thrill of discovering the first application of ...

#### ACKNOWLEDGEMENTS

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pp. vi-vii

The ideas underlying Chapters 7 and 8 originated in remarks made by Merton H. Miller. We are much indebted to Steven N.S. Cheung for writing the Foreword, to P.R. Chandrasekaran, Michael C.H. Chan, Raymond SY. Cheung, the Rt. Hon. Lord Griffiths, Ziqi Liao, Kah Hwa Ng and Lars Werin for encouragement and comments, and to Irene M.L . Cheung for expert ...

#### TABLE OF CONTENTS

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pp. ix-xi

#### CHAPTER 1 PREAMBLE

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pp. 1-5

This book is a revised and re-written version of part of a study, sponsored (from 1992 onward) by Cypress International Investment Advisors Ltd. Its purpose is to describe a new approach to the valuation of options on foreign exchange . Though the core of the original text remains , comments, especially from professional practitioners, have led the authors ...

#### CHAPTER 2 DEFINITIONS AND TERMINOLOGY

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pp. 6-9

Very briefly, let us summarise the definitions and terminology that will be used in the following chapters. There are two basic types of options: call options (or simply calls), and put options (or puts). A call option on an asset gives the owner the right to buy the asset on or before a certain date at a certain price. If the right is exercisable only on that date, the option ...

#### CHAPTER 3 TECHNICAL GLOSSARY

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pp. 10-18

The technical terms and results which will be used in the exposition are summarised i n this Chapter. For details and proofs, the reader is referred to any good text on stochastic processes, e.g., Karlin & Taylor (1975, 1981). Let (Q, A, P) be a probability space, and T an arbitrary set of numbers. A stochastic process is a family {X(t,w)} of such functions. For any given ...

#### CHAPTER 4 STOCHASTIC ASSUMPTIONS AND OPTION PRICING

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pp. 19-23

In Chapter 1 we suggested that, since option pricing is applied economics, the choice of assumptions is a matter of primary importance. In particular, we referred to the view of Cox & Ross (1976), that i f a different assumption is introduced regarding the stochastic behavior of an asset price, generally a different formula to price options on the asset would ...

#### CHAPTER 5 THE BLACK-SCHOLES OPTIONS THEORY

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pp. 24-42

As we have seen in Chapter 4, the question is: what is the equilibrium price of an option, given its nature (whether it is American or European), exercise price, exercise date, the current price of the underlying asset, the discount rate, and given an assumption regarding the behavior of the asset price over time? A major breakthrough was achieved when Black & Scholes ...

#### CHAPTER 6 GEOMETRIC BROWNIAN MOTION, "ALMOST CERTAIN RUIN", AND ASSET MARKETS EQUILIBRIUM IN OPTIONS PRICING

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pp. 43-69

At the same time that he introduced geometric Brownian motion into finance, Samuelson (1965) pointed out that if asset prices are modelled in this way, a bias in the (Brownian) random walk must be taken into consideration. In this Chapter, we first explore some implications of Samuelson's observations for the interpretation o f asset markets equilibrium, in ...

#### CHAPTER 7 NON RANDOM WALK EFFECTS AND A NEW STOCHASTIC SPECIFICATION

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pp. 57-70

As we have seen in Chapter 5, a serious problem arises when geometric Brownian motion is used to model asset prices. In addition, recent research is beginning to "question the random walk dogma" associated with geometric Brownian motion (Samuelson 1991). One factor which may account for "runs " in the prices of assets like stocks is provided by standard ...

#### CHAPTER 8 PRICING FOREIGN EXCHANGE OPTIONS INCORPORATING PURCHASING POWER PARITY

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pp. 71-86

One of the most useful and widely used applications o f the theory of options is to price options on foreign exchange.2 A s we have seen in Chapter 4, according to a fundamental assumption in Black and Scholes' theory, the stochastic process governing the (spot) price of the underlying foreign currency follows geometric Brownian motion.3 A s a result, the exchange ...

#### CHAPTER 9 CONCLUSIONS

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pp. 87-89

The appropriate choice of assumptions is a matter o f primary importance in applied economics. In option pricing, it is generally assumed that the underlying asset has a price which fluctuates over time as a geometric Brownian motion. Since a number of problems then arise, the present volume proposes an approach to the valuation of foreign exchange options ...

#### A Note on Software

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p. 89-89

A software package to compute the prices of foreign exchange options using formula (7.15) is being developed by the authors, under sponsorship ...

#### Index

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pp. 90-91

E-ISBN-13: 9789882202535

Print-ISBN-13: 9789622094543

Page Count: 104

Publication Year: 1992