Pricing non-deliverable options on the Chinese yuan

The Black-Scholes option pricing model assumes that stock prices follow a log-normal distribution. Options on those stocks then follow a partial differential equation known as the Black-Scholes equation. Other writers have extended this approach to currency options. However, this work has mainly assumed floating-exchange rates, meaning the exchange rate involved in the currency option also follows a log-normal distribution. Options on currencies like the Chinese yuan, which follow a steadily increasing trend, would be priced incorrectly given this assumption. I derive the closed-form version of a model with a trend-stationary, stochastic volatility exchange rate and then test its ability to price options on the Chinese yuan. The model will help institutions more accurately hedge their foreign exchange risk in a world in which the yuan\u27s value is increasingly important