Globalization, Gating, and Risk Finance

7Financial Currency Pricing, Swaps, Derivatives, and Complete Markets

Motivation

FX time series and models, although generally available, are nevertheless complex and multivariate due to the many factors they entail. They span a wide range of economic factors that encompass sovereign financial, economic, and political factors and their interrelationships. To simplify, factors such as sovereign interest rates, the CPI, trade, macroeconomic statistics and their simultaneous and interactive effects define FX prices. As a result, theoretical FX pricing models are many and varied. Some models are derived from multiple economic and financial factors priced in sovereign currencies, others are defined relative to baskets of currencies, and some are defined by empirically tested models. The approaches that we consider in this chapter are essentially based on fundamental and market‐based financial currency models, as well as on tracking models. In addition, we shall consider off‐market financial exchange models and swaps, used profusely by corporate firms seeking protection from currency risks and by speculators (see also Chapter 8).

7.1 Introduction

FX prices are derived from real and financial assets as well as from macroeconomic policies and statistics, regulation, interest rates, and other factors; for example, off‐market events such as political and natural and significant events. In many instances, they are also priced relative to a basket of currencies, tracking other currencies’ ...