Abstract
This paper investigates the pricing of dollar-denominated cross-currency warrants (options) traded in US markets. In a Black-Scholes setting, we obtain closed-form option pricing formulas for European warrants. We describe the intuition behind the differences in the properties of these securities versus standard foreign currency options, concentrating on parameter sensitivity as well as hedging aspects. We show that US cross-currency warrants can be hedged using three underlying assets although the fundamental PDE involves only one asset. This analytical framework is applied to observed prices for AT&T's NYSE-traded US yen/DM cross-currency warrant. We examine and attempt to explain the deviations between model and observed prices uncovered by the empirical work. We find evidence of misspecification in standard currency option-pricing models. (JEL F31).
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