Foreign Market Derivatives
In this chapter, an arbitrage-free model of the domestic security market is extended by assuming that trading in foreign assets, such as foreign risk-free bonds and foreign stocks (and their derivatives), is allowed. We will work within the classical Black-Scholes framework. More specifically, both domestic and foreign risk-free interest rates are assumed throughout to be nonnegative constants, and the foreign stock price and the exchange rate are modelled by means of geometric Brownian motions. This implies that the foreign stock price, as well as the price in domestic currency of one unit of foreign currency (i.e., the exchange rate) will have lognormal probability distributions at future times. Notice, however, that in order to avoid perfect correlation between these two processes, the underlying noise process should be modelled by means of a multidimensional, rather than a one-dimensional, Brownian motion. Our main goal is to establish explicit valuation formulas for various kinds of currency and foreign equity options. Also, we will provide some indications concerning the form of the corresponding hedging strategies. It is clear that foreign market contracts of certain kinds should be hedged both against exchange rate movements and against the fluctuations of relevant foreign equities.
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