Essays On International Asset Pricing PDF Download

Essay2. We study the pricing of illiquid cross exchange rate options by identifying stochastic discount factors embedded in currency triangles. We develop dynamic models of stochastic discount factors, under which the stochastic discount factor in each economy is decomposed into a global diffusion risk component and a country-specific jump-diffusion risk component. Separate stochastic time changes are further applied to the two components so that stochastic volatilities can come separately from both global and country-specific risks. We propose to identify both the global and the country-specific risks for three economies using options on the three currency pairs that form a currency triangle. Then, by incorporating options on any other currency pair that links to one of the three economies, we can also identify the country-specific risk dynamics in the fourth economy and thus price options on currency pairs that involve the fourth economy.