Pricing Currency Options in the Presence of a Target Zone

Abstract

The paper characterizes the class of all one dimensional diffusion exchange rate processes that lie strictly inside a target zone. This characterization is done in the risk-neutral probability, which is practically all that is needed for the purpose of option pricing. The basic version of the model is extended to a model for pricing options on a single currency which is included in a target zone-constrained currency basket. Another extension is the calibration of the model so that it is consistent with any given domestic term structure of interest rates.

JEL Classification: F31, E31, E52