Quanto Adjustments in the Presence of Stochastic Volatility

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Figure 2: Implied volatilities for different correlation values We denote the extended model as double SV model and note that the correlation matrix between the Brownian motions W QX QX S , Wν , W QX QX Z , Wν is given by ⎛ ⎞ 1 ρS,ν ρS,Z ρS,νF X ⎜ ρS,ν ⎜ 1 ρν,Z ρν,νF ⎟ X ⎟ ⎜ ρS,Z ρν,Z ⎜ 1 ρZ,νF ⎟ X ⎟ ⎝ ⎠ . ρS,νF X ρν,νF X ρZ,νF X 1 We reduce the dimensionality of the correlation matrix by choosing the parametric form: ρS,νF X = ρS,ZρZ,νF X , ρν,Z = ρS,νρS,Z, ρν,νF X = ρS,νρS,ZρZ,νF X , which matches correlation assumptions made by Dimitroff et al. [1] and also corresponds to the correlation parametrization with parameter β = 0 used by Jäckel [5]. 6 For the calibration of the double SV model we determine the stochastic volatility parameters of ν the same way we did before and in addition obtain the FX parameters νF X,0, κF X, θF X, δF X and ρZ,νF by an analog calibration to standard options on the FX rate. The correlation X parameter ρS,Z is then set such that the model price of the quanto forward is matching quanto forward given by the market. In absence of closed-form solutions for the prices of the quanto forward and quanto options in the double SV model we apply standard Monte Carlo methods to compute these prices numerically and use the following equations in this context: 7,8 F q (t, T ) = e (rY −r X )(T −t) E Q X C q (t, T, K) = e −rX (T −t) E Q X � S(T ) ZY/X (T ) ZY/X � , (t) � (S(T ) − K) + Z Y/X (T ) Z Y/X (t) 6 Jäckel [5] demonstrated that the specific choice of the parameter β used in his correlation parametrization does not have a significant impact on the prices of quanto options as long as the model is always calibrated to a given quanto forward. 7 See Jäckel [4] or Dimitroff et al. [1] for a simple derivation of the equations. 8 In the interest of brevity, we do not perform the change of measure to the domestic risk-neutral measure Q Y for the double SV model which would results in similar additional quanto adjustments as seen in the previous sections. 8 � .
Table 3: Model Parameters for Double SV Model ν0 κ θ δ ρS,ν νF X,0 κF X θF X δF X ρZ,νF X ρS,Z 0.175 0.103 0.131 0.187 -0.815 0.147 0.547 0.101 0.092 -0.34 0.62 Table 4: Prices of quanto call options. The numbers in parentheses are sample standard deviations. Strike Double SV model SV model DFAQ BS QFAQ BS QFAQ SV 70 32.44 (0.013) 32.46 32.90 33.10 33.10 80 25.21 (0.011) 25.24 25.75 26.03 26.03 90 18.66 (0.010) 18.70 19.25 19.60 19.60 100 12.95 (0.008) 12.98 13.54 13.94 13.94 110 8.26 (0.007) 8.30 8.80 9.20 9.20 120 4.80 (0.005) 4.82 5.22 5.56 5.56 130 2.57 (0.004) 2.58 2.86 3.07 3.07 Calibrating the double SV model to the same market data as used before, we obtain the model parameters listed in Table 3. Based on the calibrated model parameters for the two stochastic volatility models we now compare the model prices for Euro quanto call options on the S&P 500 index with a maturity T = 3 years. We also include in our comparison option prices calculated using the following three commonly used ad-hoc methods for quanto options: • Domestic-Forward-ATM-Quanto Black-Scholes (DFAQ BS) method • Quanto-Forward-ATM-Quanto Black-Scholes (QFAQ BS) method • Quanto-Forward-ATM-Quanto Stochastic Volatility (QFAQ SV) method The DFAQ BS method is simply using Black’s formula with the given quanto forward F q,market (T ), the discount factor belonging to the payment currency Y and with a volatility for the underlying equal to the implied volatility of the corresponding non-quanto option with the same strike K and the same maturity T as the quanto option. 9 The QFAQ BS method only differs from the DFAQ BS method by using a quanto forward adjusted volatility for the underlying which is the implied volatility of the non-quanto option with the same maturity T but with the adjusted strike ˆ K = K × F X (T )/F q,market (T ) where F X (T ) is the forward of the underlying asset under the foreign measure Q X . 10 Finally, the QFAQ SV method is using the closed-form solution for non-quanto standard options in the assumed stochastic volatility model for the underlying S but replacing the forward with the quanto forward F q,market (T ) and the discount factor with the discount factor belonging to the payment currency Y . All three approximations are commonly used in practice as outlined by Jäckel [5] from which we have also borrowed the notation for the three methods. Please note that all three common methods do not feature the additional quanto adjustment in the volatility. The results are summarized in Table 4 and reveal that the three standard methods produce prices which are almost 100 basis points higher than the prices of our two stochastic volatility models. 11,12 These higher prices can be explained by the lack of the quanto adjustment in the volatility which causes the standard methods to use a higher effective volatility for the pricing of quanto options. Note that the observed price differences are above the usual bid/offer spreads of less 50 basis points for quanto options in the OTC market which strongly suggests that ignoring the quanto adjustment in the volatility can lead to mispricing of quanto options. In contrast to this, the prices of our reduced stochastic volatility model of Section 2 agree well with prices of the fully fledged double SV model listed in Table 4. This indicates that the price impact of the FX implied volatility skew on standard quanto options is small and that our closed-form solutions derived in Section 3 could well be used for an efficient pricing and risk 9 In order to rule out that calibration errors resulting from the calibration of the stochastic volatility model to the market data potentially overshadow the model comparison we use the implied volatilities induced by the stochastic volatility parameter listed in Table 1 throughout the comparison. 10 Intuitively speaking, the QFAQ BS method is trying to reflect the different ”moneyness” of the quanto option in comparison to the nonquanto option with the same strike caused by the different forwards. 11 The prices of options as well as the strikes are expressed as a percentage of the underlying spot in the Table 4. 12 Note that the QFAQ BS method and the QFAQ SV method yield exactly the same prices in our model setting which is due to the fact that the price functions for a non-quanto call option in the Black Scholes model and the stochastic volatility model are both homogeneous with respect to the forward and the strike. 9
Page 1 and 2: Quanto Adjustments in the Presence
Page 3 and 4: Furthermore, we assume an investor
Page 5 and 6: with suitable probabilities P1 and
Page 7: Table 1: Model Parameters ν0 κ θ
Page 11: A Appendix Lemma 1. Let ν be a mea

Quanto Adjustments in the Presence of Stochastic Volatility

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