Pricing foreign currency options under stochastic interest rates

Abstract

In this paper, we build a general framework to price contingent claims on foreign currencies using the Heath et al. (1987) model of the term structure. Closed form solutions are obtained for European options on currencies and currency futures assuming that the volatility functions determining the term structure are deterministic. As such, this paper provides an example of a bond price process (for both the domestic and foreign economies) consistent with Grabbe's (1983) formulation of the same problem.