[R-SIG-Finance] [R-sig-finance] Domestic risk free rate in FX option
spencer.graves at prodsyse.com
Mon May 11 03:12:50 CEST 2009
This is a deep question for which I do not have an answer.
However, I will contribute some comments, inviting others to comment
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.
> 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
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