Foreign exchange option pricing in the currency cycle with jump risks

Abstract

This paper examines regime switching behavior and the nature of jumps in foreign exchange rates, as well as their implications in currency option pricing. Considering the characteristics of long swing as well as the short term jumps in exchange rates, we adopt the regime-switching model with jump risks to capture the movement of exchange rates in the developed and emerging countries. Our results show that ‘high-variance’ and ‘low-variance’ describes most of our sample currencies’ trajectories. The regime-switching model with jump risks is proven to capture better exchange rate changes than the regime-switching model (RSM) and the Black–Scholes model (BSM). In addition, our results show that the currency option pricing model when considering regimes of high-variance or low-variance states as well as the jump nature of exchange rates, is better than the traditional BSM and RSM.