Pricing of Currency Options in Credible Exchange Rate Target Zones: an Extension and an Alternative Valuation Approach.

The paper examines pricing of options on target zone exchange rates. The pricing model of Dumas, Jennergren and Näslund (1993) is extended to asymmetric burden sharing in the defence of the target zone. This extension is relevant for various realistic set-ups, such as unilateral target zones. The paper also introduces an alternative pricing model that, in the tradition of Black and Scholes (1973), starts from geometric Brownian motion in which, however, the target zone limits are explicitly taken account of. This approach has a strong appeal from the practical point of view as it is less demanding in terms of required pricing inputs. This, however, goes at the cost of ignoring target zone nonlinearities. Simulations show that the simpler alternative model in most relevant cases moderately underprices by 1% to 3%.