The Relative Valuation of American Currency Spot and Futures Options: Theory and Empirical Tests

Abstract

This study empirically tests contingent claims pricing models for American currency spot and futures options. Numerical analysis indicates that the difference in the model prices of spot and futures put (call) options (with the same exercise price and maturity) is, for a premium (discount) currency, positive and an increasing function of (a) the absolute dif? ference in the prices of the underlying spot and futures contracts and (b) the maturity of the options. Tests on British pound, Deutsche mark, and Swiss franc options indicate many violations ofthe ordinal pricing relationships noted above. Additional tests indicate that option prices are inconsistent with functional relationship (b) above. Most of the ob? served violations are sufficiently large to provide arbitrage profits net of transaction costs, assuming interest rates are constant and the Interest Rate Parity theorem holds continu? ously. Alternatively, both the violations and the inconsistent functional relationship may be due to violation of the assumption of constant interest rates.