Chapter 31

Foreign Exchange Markets

In this chapter, we continue to progress toward our integrated measure of interest rate risk, market risk, liquidity risk, and credit risk using the Jarrow-Merton put option concept from Chapter 1. A high percentage of smaller financial institutions have the luxury of financial assets and liabilities that are almost all denominated in a single currency. In fact, due in part to the advent of the euro, the percentage of financial institutions in this situation is rising. Nonetheless, for most of the largest financial institutions, foreign currency risk is a critical element of total risk. As van Deventer and Imai (2003) showed with respect to the Korean Development Bank and many other issuers, credit risk and foreign exchange rates of the home country can move very strongly together.

The Heath, Jarrow, and Morton (HJM) term structure model approach of Chapters 6 through 9 again provides a sound foundation with which to approach foreign currency denominated securities and derivatives. This chapter is heavily based on the HJM approach to foreign exchange (FX) options valuation of Amin and Jarrow (1991) and their paper, “Pricing Foreign Currency Options under Stochastic Interest Rates.” The variety of FX-related securities is great, but we will limit ourselves to an introductory view of the HJM approach’s implications for FX analysis. In this chapter, we concentrate solely on foreign exchange forward contracts and European options on the spot foreign ...

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