SFB 303 Discussion Paper No. B - 048

Author: Sondermann, Dieter
Title: Currency Options: Hedging and Social Value
Abstract: In this paper I shall first present a brief outline of the theory of hedging on non-redundant contingent claims as required for the hedging of currency options. We then will address another problem with the pricing and hedging of currency options, i.e. the stochastic volatility of the underlying security price process. Only if this volatility is constant over the hedging period and known in advance, the option would be theoretically redundant in the sense of Hakansson. But whenever the estimate is different from the true volatility the option is no longer attainable even in the simple Black-Scholes model and thus non-redundant. Moreover, in particular the volatility of foreign exchange rates show significant random fluctuations, thus moving currency options far away from being attainable. Finally we discuss the effects of currency options and their hedging on the volatility of the foreign exchange markets and their role in the allocation on individual and social exchange risks. We conclude with some recommendations of how to use these financial instruments for central bank interventions in order to smooth exchange rate movements.
Creation-Date: August 1986
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