Abstract
This paper clarifies and extends recent currency option pricing research that attempts to incorporate stochastic domestic and foreign interest rates. We give an alternative perspective on the currency option pricing model of Milliard, Madura, and Tucker (1991) by identifying it with the constant forward rate volatility term structure model of Heath, Jarrow and Morton (1992). The arithmetic random walk process for the instantaneous short rate, considered by Hilliard, Madura and Tucker (1991) for the empirical testing of their currency option pricing model, is shown to imply an unreasonable shape for the term structure of interest rates. We show that the pricing of currency options can be consistent with an initially observed term structure of interest rates (both domestic and foreign) and independent of investors' preferences.
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