REALIGNMENT RISK AND CURRENCY OPTION PRICING IN TARGET ZONES

This paper extends the Krugman target zone model by including a realig nment mechanism. Various properties of that realignment mechanism are discussed. The movement of the exchange rate is governed both by a Wie ner process on fundamental and by a Poisson jump process with endogeno us realignment size. The realignment mechanism is such that (except in cases where a speculative attack occurs) no jump in fundamental is ne eded to accompany the jump in the exchange rate. A risk neutral valuat ion of currency options is constructed. Some properties of option valu es under realignment risk are illustrated by numerical results.