THE DISTRIBUTION OF EXCHANGE-RATE RETURNS AND THE PRICING OF CURRENCYOPTIONS

An empirical model of the distribution of exchange rate returns based on a combination of the generalized Student t distribution and conditi onal variance specifications, is formulated and estimated for four dai ly bilateral exchange rates over the period 1984 to 1991. The empirica l results show that the stylized characteristics of exchange rate retu rns such as volatility clustering, leptokurtosis and skewness, are con sistently captured by this model, in contrast with other model specifi cations based on more restrictive distributional assumptions. Implicat ions of the analysis are also investigated for the pricing of currency options, including comparisons with Black-Scholes prices. (C) 1998 El sevier Science B.V.