An empirical examination of currency futures options under stochastic interest rates
Global Finance Journal
Futures option markets have experienced significant growth over the past decade as the contracts traded in 1992 were worth over 836 billion U.S. dollars. Despite the extensive empirical testing of option-pricing models for the spot option markets, only a few studies have empirically tested option pricing models for the rapidly growing currency futures market.
Along with the expanding options on spot security markets, futures option markets have experienced significant growth in terms of trading volume in recent years. The trading of options on futures contracts started in 1983. Since then, the annual volume of futures options traded has grown from 281,090 contracts in 1983 to 26,739,210 contracts in 1992. That is, the annual trading volume of contracts in 1992 is about 95 times the trading volume in 1983, with approximately 37% of them being options on currency futures according to the annual volume statistics obtained from the Chicago Mercantile Exchange (CME). Ball and Torous (1986), Shastri and Tandon (1986a), and Ogden and Tucker (1987, 1988) conducted empirical studies investigating the currency futures options market using constant interest-rate option pricing models. With the recent development of new models, assumptions such as a constant interest rate have been relaxed.
In contrast to most of the past studies, the primary objective of this paper is to empirically examine the impact of stochastic interest rates on currency futures option valuation. This study examines option contracts on five currency futures-the British Pound, Canadian Dollar, German Mark, Japanese Yen and Swiss Franc traded during the period January 1, 1991 to December 31, 1992. By explicitly accounting for stochastic interest rates, a stochastic interest-rate optionpricing model may lead to better estimates of the value of options on currency futures than a constant interest-rate model. In order to accomplish the primary objective of this research, the examination of the stochastic pricing model includes two parts:
- The price estimates from a stochastic interest rate model compared with actual observed currency futures option values.
- Comparisons between the price estimates from a stochastic interest-rate option pricing model and those from a constant interest-rate option pricing model.
The paper is organized as follows: Section II provides an overview of a sample of the literature in this area. Section III describes the sample data and the methodology. Empirical results are presented and discussed in Section IV with discussion and conclusions given in Section V.
Copyright © 1998 by JAI Press Inc.
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Poon, W. P. H and Duett, E. H. (1998). An empirical examination of currency futures options under stochastic interest rates, Global Finance Journal, 9(1), 29-50. doi:10.1016/S1044-0283(98)90013-8