A Generalized Framework for Valuing Currency Futures Options

Abstract

In valuing foreign currency futures options, it has been common to assume that the Interest Rate Parity is correct, and forward and futures contracts are perfect substitutes for each other. It is conceivable that this practice may bring in institutional bias, especially as the life of a futures contract increases and the interest rates are not constant. In this paper we develop a generalized analytic framework for valuing currency futures options. The framework is general in the sense that it is consistent with the current models, can incorporate dynamic volatility and dynamic term structure of interest rates, while not making the unnecessary assumptions.