Oldfield, George S.; Messina, Richard J.
September 1977
Journal of Financial & Quantitative Analysis;Sep77, Vol. 12 Issue 3, p473
Academic Journal
Recent work in the valuation of speculative investment instruments has focused on hedging theories in a dynamic efficient market framework. The hedging analysis proceeds by demonstrating that a combination of long and short positions in various securities can be used to create an instantaneous risk-free hedge. If the risk-free position is continuously adjusted during some period as security prices randomly fluctuate, then efficient market theory indicates that the hedged investment's holding period return must be the risk-free rate of interest. This paper uses a continuous time hedging model to derive the interest rate parity theory of foreign exchange as an efficient market equilibrium condition. The analysis is similar to Black's [1] discussion of commodities future contracts. The next section of this paper briefly reviews the development of the interest rate parity theory in a static framework. This is followed by a statement and discussion of the assumptions used in the continuous time analysis. The mathematical treatment of hedging in a random walk spot exchange market is presented in the fourth section.


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