EXCHANGE-RATE SHOCKS, CURRENCY OPTIONS AND THE SIEGEL PARADOX

This note explores the relationship between risk and premium in foreign exchange rates. We show that investors in different countries demand different premiums for the same source of risk. The difference in the premiums is related only to the volatility of the source of risk and not to investor risk attitudes. We show how this difference is consistent with arbitrage pricing and that any contingent claim on the exchange rate has a unique price, even when the exchange rate can jump. In particular, we resolve the seeming inconsistency reported by Dumas et al. (1993a) for jump models of exchange rates.