The valuation of European call options on zero-coupon bonds in the run-up to a fixed exchange-rate regime

We analyze the dynamics of zero-coupon bond options in a situation in which the currently floating exchange rate between two countries' currencies is announced to be fixed on a given future date. To this end, we combine two strands of research that have been treated as separate issues up to date. In particular, we make use of recent theoretical work on continuous-time dynamics of exchange rates and interest-rate differentials between the economies involved (as provided by the international-economics literature) and derive a closed-form pricing formula for a European call option on zero-coupon bonds (by means established in the classical finance literature). In a Monte-Carlo simulation study we show that significant option-pricing errors can occur when the key features of interest-rate dynamics during the run-up to the fixed exchange-rate regime are ignored. •We consider a regime switch from floating to fixed exchange rates.•We derive the domestic interest (short) rate dynamics prior to the fixing.•We derive pricing formulas for European call options on zero-coupon bonds.•In a simulation study we assess the validity of our option-pricing formulas.•Large pricing errors can occur by ignoring key features of our short-rate dynamics.