[R-SIG-Finance] [R-sig-finance] Domestic risk free rate in FX option

[spencerg]

      This is a deep question for which I do not have an answer.  
However, I will contribute some comments, inviting others to comment 
further. 


      A few years ago, I considered making foreign investments.  I was 
advised against it, because I plan to spend most of my money for the 
rest of my life in my local currency.  In essence, foreign investments 
add the risk of exchange rates to the risk of the investment itself. 


      This suggests that the "domestic risk free interest rate" should 
be be local to the investor.  If you live in the US and you expect the 
vast majority of your expenses today and in the future to be in US 
dollars, then your "domestic risk free interest rate" would likely be 
based on US Treasuries, and your estimates of volatility need to include 
the volatility in the exchange rates between the dollar and the currency 
in which the forex option is traded. 


      Similarly, if you live in Timbuktu and most of your financial 
dealings today and in the future are in the local currency, CFA Francs, 
then maybe you need a "risk free rate" somehow tied to CFA Francs. 


      I doubt if this answers your question, but I hope it helps. 

      Best Wishes,
      Spencer Graves


RON70 wrote:
> In CME, option on forex is traded on EUR/GBP. If I want to price this option
> using some pricing formula then as Domestic risk free interest rate what
> should I take? Shouldn't risk free rate in UK be appropriate? I am asking
> this because as CME is in US, domestic currency is USD. Your suggestion
> appreciated.
>