The Jump Risk of Exchange Rate and Its Impact on RMB Forward Contracts Pricing

Since the implementation of a new exchange rate system entitled managed floating based on supply and demand and reference from a basket of currency in 2005, the exchange rate between RMB and other currency becomes more and more volatile and consequently causes a distinct risk to relative economic agents. Particularly, spot exchange rate under this new management system is much possible to make large movement or jumps in short time interval, thus induces a special type of risk, i.e., jump risk. In this paper, we propose a new stochastic model, SVDJ model which has allowed for jump risk, to describe the dynamics behavior of spot exchange rate, and develop a MCMC (Markov Chain Monte Carlo) method for the estimation of parameters, jumps, and volatility. Based on the model, we finally deduce the pricing formulation for RMB forward contract (RMB forward), as well as considering the jump risk impact on its pricing. Our empirical results indicate the significant existence of jumps in exchange rate process, and the incorporation of jump risk in exchange rate process is important for RMB forwards pricing. We also have compared our model with other traditional models, such as B-S model, and Heston´s SV model. The results favorite our proposed model with respect to the performance of the forwards pricing.