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Exchange rate and term structure dynamics and the pricing of derivative securities

Author: Nielsen, Lars Tyge ; Saá-Requejo, JesúsINSEAD Area: Finance Series: Working Paper ; 92/72/FIN Publisher: Fontainebleau : INSEAD, 1992.Language: EnglishDescription: 42 p.Type of document: INSEAD Working PaperAbstract: We develop a two-country version of the CIR (1985) model. It involves a two-factor term structure of interest rates in each country. The two state variables, which are the same for both countries, are the instantaneous interest rates in the two countries. The two term structures are correlated and interdependent through an explicit dependence of the yields of bonds issued in one country on the interest rate in the other country. We also obtain the endogeneous stochastic process followed by exchange rate. Unlike the CIR model, ours does not imply that the instantaneous returns on bonds of all maturities are perfectly correlated. We present a partial differential equation for valuing exchange-rate and interest-rate sensitive contingent claims, and we derive closed-form expressions for discount bonds, forward exchange rates and futures exchange rates
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We develop a two-country version of the CIR (1985) model. It involves a two-factor term structure of interest rates in each country. The two state variables, which are the same for both countries, are the instantaneous interest rates in the two countries. The two term structures are correlated and interdependent through an explicit dependence of the yields of bonds issued in one country on the interest rate in the other country. We also obtain the endogeneous stochastic process followed by exchange rate. Unlike the CIR model, ours does not imply that the instantaneous returns on bonds of all maturities are perfectly correlated. We present a partial differential equation for valuing exchange-rate and interest-rate sensitive contingent claims, and we derive closed-form expressions for discount bonds, forward exchange rates and futures exchange rates

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