Pricing of Quanto Options

Pricing FX Quanto Options under
Stochastic Volatility
A dissertation submitted to the

WARWICK BUSINESS SCHOOL
UNIVERSITY OF WARWICK
in partial fulfillment of the requirements for the degree of

MSc in Financial Mathematics
submitted by
TANMOY NEOG (0850324)
supervised by
Prof. Dr. Nick Webber
7 September, 2009
All the work contained is my own unaided effort and conforms to the University guidelines on
plagiarism
Acknowledgment
I would like to begin by thanking my supervisor Prof. Nick Webber. I thank him for his patient
guidance and his enthusiasm to answer my questions. This dissertation introduced me to the
intricacies of derivative pricing. It was the enthusiasm of my supervisor that gave me the impetus
to try to improve my results. Hopefully I did not do very badly. I also thank the WBS authorities
who ensured that we had the adequate facilities to work efficiently.
I thank all the faculty members involved with the Financial Mathematics course. I could learn a
lot from the rigour involved in this course. I thank my batchmates Vineet Thakkar, Zenon, Ravi
Ganesan and Piyush Singh for several discussions related to Financial Mathematics. Coming
from a background where I had no knowledge of Computational Finance; these individuals
helped me to learn a lot of things in lesser time than I would have taken. Last but not the least
special thanks to my dear friend Vallu with whom there was never a dull moment.
ii
Contents
List of Figures vi
List of Tables viii
Abstract x
1 Literature Review 4
1.1 Bennett and Kennedy’s methodology for pricing the FX Quanto Option . . . . . 4
1.2 Pricing the FX quanto option under different frameworks . . . . . . . . . . . . . 7
2 Pricing FX Quanto Options in the Black Scholes Framework 14
2.1 The standard market practice in pricing FX Quanto Options . . . . . . . . . . . 14
2.1.1 Pricing using the Black Scholes Model . . . . . . . . . . . . . . . . . . . . 15
3 Pricing of FX Quanto under the Heston Model 17
3.1 Revisiting the Heston model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.2 Option Pricing under the Heston model . . . . . . . . . . . . . . . . . . . . . . . 18
3.2.1 The Heston Pricer using Fast Fourier Transform . . . . . . . . . . . . . . 19
3.2.2 The Heston Trap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
3.3 The Heston model with jumps . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
iii
3.4 Pricing the FX Quanto option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
4 Pricing of FX Quanto under the GARCH Option Pricing Model 26
4.1 Duan’s GARCH Option Pricing Model . . . . . . . . . . . . . . . . . . . . . . . . 26
4.2 Analytical Approximation of the GARCH Option Pricing Model . . . . . . . . . 28
5 Modelling the Dependence Structure Using a Copula 31
5.1 Archimedean Copulas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
5.1.1 Archimedean Copulas and their Measures of Dependence . . . . . . . . . 33
5.1.2 Identifying the Right Copula from the Archimedean Family to Model the
Dependence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
5.2 The T Copula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
5.2.1 Calibration of the T Copula . . . . . . . . . . . . . . . . . . . . . . . . . . 38
5.3 Pricing using the copula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
6 Data 41
6.1 Discount Factors, Implied Volatility quotes . . . . . . . . . . . . . . . . . . . . . 41
6.2 Recovering Strikes and Prices of FX vanilla options . . . . . . . . . . . . . . . . . 42
7 Implementation of Pricing Methods 45
7.1 Implementation of the Heston Stochastic Volatility Model with Jumps . . . . . . 45
7.1.1 Calibration of the Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
7.1.2 Finding Implied Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
7.2 Implementation of the GARCH Option Pricing Model . . . . . . . . . . . . . . . 50
7.2.1 Calibration Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
7.3 Choosing a model to price the Quanto option . . . . . . . . . . . . . . . . . . . . 56
7.4 Results of pricing the quanto option . . . . . . . . . . . . . . . . . . . . . . . . . 56
iv
7.5 Implementing a copula to price the FX quanto option . . . . . . . . . . . . . . . 58
7.5.1 Parameter estimation for the T Copula . . . . . . . . . . . . . . . . . . . 59
7.5.2 Parameter estimation for the Frank Copula . . . . . . . . . . . . . . . . . 60
7.5.3 Calibration of marginals . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
7.5.4 Numerical Results for pricing using copula . . . . . . . . . . . . . . . . . . 62
7.6 Monte Carlo Errors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
8 Conclusion 69
Bibliography 71
v
List of Figures
5.1 Frank Copula with 𝛼 = 1.5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
5.2 Clayton Copula with 𝛼 = 1.5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
5.3 Gumbel Copula with 𝛼 = 1.5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
7.1 Time series observations of USD/JPY spot exchange rate . . . . . . . . . . . . . 46
7.2 Market and model volatility(in %) for USD/YEN call options with maturity 1
months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
7.7 Market Implied Volatility Surface . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
7.8 Heston with Jumps Implied Volatility Surface . . . . . . . . . . . . . . . . . . . . 53
7.9 Canonical Log likelihood function (Mashal and Zeevi) . . . . . . . . . . . . . . . 60
7.10 Market and model volatility (in %) for EUR/USD call options with maturity 1
months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
vi
7.11 Market and model volatility(in %) for EUR/USD call options with maturity 6
months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
7.14 Market and model volatility(in %) for EUR/JPY call options with maturity 1
months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
7.17 Market and model volatility(in %) for EUR/JPY call options with maturity 2 years 65
7.18 Frank Copula with 𝛼 = 0.0075 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
7.19 T Copula with 𝜈 = 14 and 𝜌 = 0.6 . . . . . . . . . . . . . . . . . . . . . . . . . . 66
vii
List of Tables
5.1 Archimedean Copulas and their Generators . . . . . . . . . . . . . . . . . . . . . 33
5.2 Archimedean Copulas and Measures of Dependence . . . . . . . . . . . . . . . . . 34
6.1 𝑖
Discount factors 𝐷0,𝑇 corresponding to currency i and maturity T . . . . . . . . 42
6.2 EUR/USD implied volatility quotes of call options corresponding to standard

values of Black Delta and maturity T . . . . . . . . . . . . . . . . . . . . . . . . 42
6.3 EUR/JPY implied volatility quotes of call options corresponding to standard

6.4 USD/JPY implied volatility quotes of call options corresponding to standard

7.1 Parameters of Heston with jumps calibration on USD/JPY rates . . . . . . . . . 48
7.2 Parameters of GARCH calibration on USD/JPY rates . . . . . . . . . . . . . . . 53
7.3 Implied volatilities for maturity of 1 month . . . . . . . . . . . . . . . . . . . . . 54
7.4 Implied volatilities for maturity of 3 months . . . . . . . . . . . . . . . . . . . . . 54
7.5 Implied volatilities for maturity of 6 months . . . . . . . . . . . . . . . . . . . . . 55
7.6 Implied volatilities for maturity of 1 year . . . . . . . . . . . . . . . . . . . . . . 55
7.7 Implied volatilities for maturity of 2 years . . . . . . . . . . . . . . . . . . . . . . 55
7.8 Root mean squared errors for the implied volatility fits on USD/JPY FX rate . . 56
viii
7.9 Quanto prices for maturity of 1 month. Spot price is 0.0083 dollars. All the prices
are in the Euro currency.Strike prices in dollars. . . . . . . . . . . . . . . . . . . . 57
7.10 Quanto prices for maturity of 3 months.Spot price is 0.0083 dollars. All the prices
7.11 Quanto prices for maturity of 6 months. Spot price is 0.0083 dollars. All the
prices are in the Euro currency.Strike prices in dollars. . . . . . . . . . . . . . . . 58
7.12 Quanto prices for maturity of 1 year. Spot price is 0.0083 dollars. All the call
prices are in the Euro currency.Strike prices in dollars. . . . . . . . . . . . . . . . 58
7.13 Quanto prices for maturity of 2 year. Spot price is 0.0083 dollars. All the prices
7.14 Parameters for the T copula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
7.15 Parameters for the Frank copula . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
7.16 Parameters for EUR/USD and EUR/JPY after calibration . . . . . . . . . . . . 61
7.17 Root mean squared errors for the implied volatility fits on EUR/USD and EUR/JPY
FX rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
7.18 Relative Difference (RD)with Black Scholes for the models for maturity of 1
month. Values have been rounded off. . . . . . . . . . . . . . . . . . . . . . . . . 66
7.19 Relative Difference(RD)with Black Scholes for the models for maturity of 3 months.
Values have been rounded off. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
7.20 Relative Difference(RD)with Black Scholes for the models for maturity of 6 months.
7.21 Relative Difference(RD)with Black Scholes for the models for maturity of 1 year.
7.22 Average Standard Monte Carlo errors.Each error is an average of 25 simulations

for 25 different quanto options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
ix
Abstract
This dissertation looks at the pricing of FX quanto options using stochastic volatility models.
There are a lot of stochastic volatility models available. However we look only at the applicability
of the Heston model with jumps and the GARCH Option Pricing Model. By a no arbitrage
condition on FX rates we can view the FX quanto as a multi currency option. In a Black type
of model the pricing of the FX quanto depends on implied volatilities of three exchange rates.
This encourages the use of a copula function to model the dependency. We do so by pricing
the quanto with a T Copula; member of the elliptic family and the Frank Copula; a member of
the Archimedean Copula family with the marginals as Heston with jumps process. We observe
that under stochastic volatility there is a considerable difference in option prices from the Black
Scholes model. This is more so for options which have a low delta. Further given our data set
the Heston model with jumps fits the market behaviour for plain vanilla FX options better than
the GARCH Option Pricing model.
x
Introduction
In this dissertation we take up the problem of pricing a European style FX quanto option
under stochastic volatility. An FX quanto option has as its underlying an exchange rate with a
domestic and foreign currency. The payoff at maturity is converted into a third currency. This
third currency is called the quanto currency. An individual would buy a quanto call option if he
believes that the exchange rate would appreciate. Further he would expect the quanto currency
to appreciate more than the foreign currency for that particular exchange rate.
In the past various authors have priced these options in a non stochastic volatility framework.
The FX quanto is viewed as a multi asset option as volatility of the underlying exchange rate
is dependent on the volatilities of the quanto domestic and quanto foreign rates. We have a
closed form solution under the Black Scholes model for pricing FX quanto options. There have
been authors who have taken a different approach such as employing a copula to model the
dependence structure between exchange rates.(please refer to the literature review) The joint
distribution of asset prices is extracted from market implied volatilities. The price of the quanto
option is then evaluated as an integral involving the joint density of asset prices.
There have been expressions for quanto options under discrete time GARCH models which we
1
consider as well. While pricing a multi asset product like a quanto option one needs to take
into account multivariate models which can handle the co-movement of the underlying price
processes. The multivariate normal distribution is a very easy way of analyzing returns on
multiple assets. In a multivariate normal distribution the dependency between the margins is
measured by linear correlation. The actual association between the different assets may not
be so. The use of a copula is alternative measure of association between assets. The basic
idea of copulas is to separate the dependence structure between variables from their marginal
distributions.
Through the choice of copula, we can influence control on the association of certain parts of the
distribution.For instance at the tails. To give an example it may so happen that the returns of
two stocks might be correlated in the extreme tails, but not elsewhere in the distributions, and
there are copulas which can model this behaviour.
The aim of this dissertation would be to investigate as to how different quanto prices are under
a stochastic volatility framework. At first we do not incorporate a dependency between the
quanto, foreign and domestic rates. After this we do incorporate dependency through a copula.
It is unlikely that single copula family model can take care of the asymmetry of the underlying
asset process. If not then the answer could lie in perturbation of the copula family as used by
Bennett and Kennedy (2003) or mixture copulas.
I extend the standard FX quanto option pricing in two ways. First the marginals are assumed to
follow a Heston wih jumps process and the dependence is modelled using a copula. We choose a
t-copula from the elliptic family and the Frank copula from the Archimedean family. The choice
of a Frank copula is based on best fit to historical data.
2
When we model the individual FX rates as Geometric Brownian Motion as in the Black’s
formulae the log returns follow a Normal distribution. From an empirical point of view we
observe that the log returns of exchange rates we consider in this paper have a high excess
kurtosis of around 9. We need to replace GBM dynamics. Hence I take the marginals as non
linear GARCH processes. The GARCH process allows fatter tails. We use the Duan’s GARCH
Option Pricing Model for our purpose.
When using a pricing model it is important for the model to fit the market implied volatility
quotes for plain vanilla options. We observe that given our dataset the Heston with jumps model
gives us a much better fit to market quotes as compared to the GARCH model.
3
Chapter 1
Literature Review
Over the years valuation of contingent claims has been an area of extensive research. The
seminal work done by Black and Scholes (1973) and Cox et al. (1979) introduced us to risk
neutral pricing models. However there is a shortcoming of these models. The assumption of
a fixed volatility is violated in real time markets. The problem of pricing FX quanto options
in a non stochastic volatility model has been elaborately explained by Bennett and Kennedy
(2003). This paper is like a starting point for our dissertation. We give a brief review of the
methodology adopted by the authors in pricing the FX quanto options.
1.1 Bennett and Kennedy’s methodology for pricing the FX
Quanto Option
Benett and Kennedy express the payoff of a plain vanilla FX option in terms of two other
exchange rates. This is obtained from the triangular no arbitrage condition for currencies. The
4
price of this European multi asset option is written as an integral involving the joint density
of the asset prices at expiry. Hence the calculation of the price of the option involves the
integration of a joint density function of the two exchange rates. The authors then express the
joint density as a product of the marginal density functions of the individual exchange rates
and a copula function. This is done by using Sklar’s Theorem. The copula function determines
a joint density function of the two exchange rates. The use of the copula allows the authors
to separate the modelling of the marginal distributions from the modelling of the dependence
structure. The marginal densities are taken as mixture of lognormal distributions. The initial
calibration of marginal distributions to implied volatility quotes is done by a weighted non
linear least squares optimisation. This process of using option implied densities is similar to
Dupire (1994). A Gaussian copula is then used which is perturbed by a cubic spline to get a
dependence structure between the three currency pairs.The modification of the upper and lower
tail dependence characteristics through this perturbation is to allow calibration to a smile in
implied volatilities of the FX rates.
At the outset Bennett and Kennedy have considered a Gaussian copula. However to calibrate
the joint distribution to the implied volatility smile on the FX rates the dependence structure
associated with the Normal copula is perturbed. With this perturbation the tail dependence
characteristics are modified. The authors have used the following result which is due to Gen-
est(2000):
Theorem 1.1. Let 𝜑 : [0, 1] −→ [0, 1] be a continuous, twice differentiable concave function
such that 𝜑(0) = 0 and 𝜑(1) = 1. Then
𝐶𝜑 (𝑢, 𝑣) = 𝜑−1 (𝐶(𝜑(𝑢), 𝜑(𝑣))) (1.1)
5
is a copula if C(.,.) is a copula.
For Benett and Kennedy the starting point is a bivariate Normal distribution with correlation
parameter 𝜌. A transformation function is then used to modify tail dependence. I will give a
review of how the authors obtained 𝜑 later. I proceed by giving a mathematical form of the
transformation function.
The Normal Copula has the density function as
𝐶Normal (𝑢, 𝑣∣𝜌) = 𝑁𝜌 (𝑁 −1 (𝑢), 𝑁 −1 (𝑣)) (1.2)
In equation (1.2) 𝑁𝜌 denotes the standard bivariate normal distribution with correlation 𝜌. 𝑁
denotes the standard univariate Normal distribution function. To obtain the density of the
transformed copula 𝐶𝜑 the partial derivatives of equation (1.1) with respect to both arguements
are taken. Bennett and Kennedy obtain 𝑐𝜑 (𝑢, 𝑣), the density of the transformed copula as
𝜑′ (𝑢)𝜑′ (𝑣) ( 𝜑′′ (𝐶𝜑 (𝑢, 𝑣)) 𝑑𝐶 𝑑𝐶 )

𝑐𝜑 (𝑢, 𝑣) = 𝑐(𝜑(𝑢), 𝜑(𝑣)) − (1.3)
𝜑′ (𝐶𝜑 (𝑢, 𝑣) [𝜑′ (𝐶𝜑 (𝑢, 𝑣)]2 𝑑𝑢 𝑑𝑣
The final step which we can observe from equation (1.3) is to find the transformation function
𝜑. From equation (1.1) we can say that the behaviour of 𝜑(𝑥) near 𝑥 = 1 controls the upper tail
dependence of the transformed copula. The lower tail dependence of the transformed copula can
be observed from the behaviour of 𝜑(𝑥) near 𝑥 = 0. The correlation 𝜌 is fixed. The authors then
change the endpoints of the transformation which enables them to change the tail dependence
characteristics. Bennett and Kennedy observe that increasing the size of the second derivative
of 𝜑 at the end points can change the tail dependence characteristics. The authors specify 𝜑 as
a cubic spline with 𝑘 + 1 suitable predefined knot points 𝑝𝑖 ∈ (−1, 1). The size of the second
derivative is an indicator of the increase in tail dependence. Hence the second derivative of the
6
spline at each knot point is first specified. The co-efficients of the spline are obtained by making
use of the requirements 𝜑(0) = 0 and 𝜑(1) = 1.Hence 𝜑 is found.
Hence if the knot points vector be denoted by p as 𝑝 = (𝑝0 , 𝑝1 , ......, 𝑝𝑘 )𝑇 with 𝑝0 = 0 and 𝑝𝑘 = 1.
The polynomial between the 𝑗 𝑡ℎ and the (𝑗 + 1)𝑡ℎ nodes is given by
3
∑
𝑆𝑗 (𝑥) = 𝑎𝑖,𝑗 (𝑥 − 𝑝𝑗 )𝑖 (1.4)
𝑖=0
for 𝑥 ∈ [𝑝𝑗 , 𝑝𝑗+1 ] and coefficients 𝑎𝑖,𝑗 which are determined from an optimisation proceedure.
The cubic spline takes the value of the polynomial function 𝑆𝑗 (𝑥) between each of the knot
points. The final outcome is that 𝜑 is determined and the vanilla call options are priced. Once
the parameters from the plain vanilla calls are obtained; these parameters are then used to price
the quanto FX option.
The resulting quanto prices under a number of real scenarios is generally close to prices under
the Black formulae. The Black model often gives lower prices for the quanto call options and
higher for put options. The relative difference is occasionally large, that is in the region of 10
to 15 percent for standard strikes furthest away from at-the-money.
1.2 Pricing the FX quanto option under different frameworks
We have a standard approach to pricing quanto FX options which is based on the Black type
model. In this dissertation we will price the FX quanto option under two diffferent frameworks.
First we consider pricing the quanto in the continuous time Heston Stochastic Volatility Model
with jumps and then under the GARCH Option Pricing Model. Comparisons with the the Black
Type model is then done.
7
The shortcomings of the Black Scholes model in pricing foreign currency options has been
shown by Melino and Turnbull (1990) . It makes a strong assumption that returns are normally
distributed with known mean and variance. Stochastic volatility models have been used by Hull
and White (1989), Scott (1987). However the methodology adopted by them to price options
was computationally intensive in the absence of a closed form solution. Heston (1993) then
came up with a semi closed form solution to price European call options when the spot asset is
correlated with the volatility. We have a more elaborate discussion with the relevant equations
on the Heston model and the Heston model with jumps in Chapter 3.
Some other continuous time stochastic volatility models are the Stochastic Alpha Beta Rho
(SABR) model and the Variance Gamma model. The SABR model was developed by Hagan
et al. (2002). The inspiration behind the SABR model was that the behaviour of market smile
produced by local volatility models was opposite to the market. Hagan et al. (2002) say that due
to this discrepancy the delta and the vega hedges derived from local volatility models could be
unstable. In this two factor model the forward asset price 𝐹ˆ and its volatility 𝑎
ˆ are correlated.
𝑑𝐹ˆ = 𝑎
ˆ𝐹ˆ 𝛽 𝑑𝑊1
𝑑ˆ
𝑎 = 𝜈ˆ
𝑎𝑑𝑊2
𝑑𝑊1 𝑑𝑊2 = 𝜌𝑑𝑡
Hagan et al. (2002) obtain the option prices from a perturbation technique and further provide
a closed form formula for the implied volatility as a function of the forward price 𝐹ˆ and strike.
Madan et al. (1998) have used three parameter option pricing method termed as the Variance
Gamma (VG) Process. At any random time a Brownian motion with drift is evaluated by using
a gamma process. The drift of the Brownian motion and the volatility of time change form the
8
other two parameters.
In continuous time stochastic models it is difficult to obtain a volatility variable from a set of
discrete observations of spot prices. There has been a lot of research in estimating volatility in
continuous time models from historical observations. We can refer to Cvitanic et al. (2006).
This problem is not inherent in discrete time autoregressive conditional heteroscedastic models
(ARCH) introduced by Engle (1982) and Bollerslev (1986). Engle (1982) was successfully able
to model properties of assets reurns having properties as fat tails and time varying variances.
There have been many extensions to Engle (1982) like the exponential GARCH model, the
non linear asymmetric GARCH models among others. The first attempt to price European
style options under the GARCH framework was by Duan (1995). He introduced the local risk
neutral valuation relationship for univariate GARCH processes. Duan (1996) successfully used
his GARCH option pricing model to fit the volatility smile and the term structure of implied
volatilities. Chaudhury and Wei (1996) did a simulation study of comparing Duan’s GARCH
model with the Black Scholes model. They found out that the GARCH model has least error
with the Black Scholes model when pricing out of the money options with a maturity of 30 days
or less.
For our situation we are interested in the applicability of the GARCH framework to the pricing
of options on foreign assets. The first work in this direction was done by Duan and Wei (1999).
In this paper the authors have modelled the foreign exchange rate and the underlying asset
process as a bivariate nonlinear asymmetric GARCH process. For our purpose of pricing the FX
quanto option the underlying is also a foreign exchange rate. The pricing framework incorporates
stochastic volatility, unconditional leptokurtosis and a correlation between the lagged return and
9
the conditional variance for both the exchange rates in question.
The inherent problem with Duan’s GARCH Option Pricing Formulae was that one had to use
a Monte Carlo scheme to price the option.There were people who worked around this problem.
We know that the discounted asset process is a martingale under the risk neutral measure. Duan
and Simonato (1999) examine that in a Monte Carlo simulation this property is violated. They
propose a technique called as the Empirical Martingale Simulation (EMS). This imposes the
martingale property on the collection of simulated sample paths. The EMS method generates
asset prices at future times 𝑡1 , 𝑡2 , ....., 𝑡𝑛 using the following system
𝑍𝑖 (𝑡𝑗 , 𝑛)
𝑆˜𝑖 (𝑡𝑗 , 𝑛) = 𝑆0 (1.5)
𝑍0 (𝑡𝑗 , 𝑛)
where
ˆ 𝑗)
𝑆𝑖 (𝑡
𝑍𝑖 (𝑡𝑗 , 𝑛) = 𝑆˜𝑖 (𝑡𝑗−1 , 𝑛) (1.6)
𝑆𝑖 (𝑡ˆ𝑗−1 )
and
𝑛
1 −𝑟𝑡𝑗 ∑
𝑍0 (𝑡𝑗 , 𝑛) = 𝑒 𝑍𝑖 (𝑡𝑗 , 𝑛) (1.7)
𝑛
𝑖=1
Here 𝑆𝑖ˆ(𝑡) denotes the ith simulated asset price at time t before the EMS adjustment. 𝑆˜𝑖 (𝑡0 , 𝑛),
𝑆𝑖ˆ(𝑡) are set equal to 𝑆0 . The steps followed in the simulation are as follows
ˆ 𝑗)
𝑆𝑖 (𝑡
1. The return from time period 𝑡𝑗−1 to 𝑡𝑗 i.e. from is first simulated.
𝑆𝑖 (𝑡ˆ𝑗−1 )
2. Equation 1.7 is used to calculate the temporary asset price 𝑍𝑖 (𝑡𝑗 , 𝑛)
3. Equation 1.8 is used to calculate the discounted sample average.
4. Finally the EMS asset price at time 𝑡𝑗 is calculated by using equation 1.6.
Duan et al. (1999) then followed up the work with an analytical approximation for the GARCH
Option Pricing Model. This approximation uses the higher order moments of the distribution
10
of log returns of the asset.We will discuss this method and the GARCH Option Pricing Model
in detail in Chapter 4.
Around the same time Heston and Nandi (2000) introduced a closed form solution to the GARCH
model. They derived the risk neutral transformations of the parameters. The characteristic
function of the asset is taken to be in a log linear form. They derived recursions for the involved
terms and finally provided an analytic expression in the Fourier domain. A good study on the
capabilities and limitations of various GARCH option pricing models is availabe in Christoffersen
and Jacobs (2004).
In the later part of the dissertation we try to extend the Heston with Jumps option pricing
framework with a copula. A similar approach has been taken by Chiou and Tsay (2008) in the
pricing of index correlation options with Duan’s GARCH Option Pricing Framework. Chiou
and Tsay (2008) extend the univariate risk neutral pricing of Duan(1995) to a multivariate case
under the copula framework. As mentioned in the introduction we use a T Copula and a Frank
Copula. In the second part of the paper the copula based model is used to assess the risk of a
portfolio comprising of assets which have the underlying of the options as investment.The assets
in this case are investments on the NYSE and TAIEX index. The copula is used to measure
the tail dependence of the asset returns. The authors come to an interesting conclusion that
no matter what kind of dependence measure is used , holding a portfolio of both indices always
has a higher chance to gain over 5 per cent than to lose more than 5 per cent. The copula
based model is then used to calculate the Value-at-Risk of the portfolio. This paper illustrates
an interesting use of the copula based approach to pricing derivatives.
There are three methods by which we could have fit an copula to our bivariate exchange rate
11
data. They are the Exact Maximum Likelihood Method(EML), the Inference Function for
Margins Method (IFM) and the Canonical Maximum Likelihood Method (CML). In our case of
fitting the T Copula we use the CML method and its application by Mashal and Zeevi (2002).
We use this method because here because we do not have to make any assumption about the
distributional form of the marginals. We review this method in detail in Chapter 5. In the
EML method we have a n-dimensional vector 𝜃 of parameters to be estimated. We denote the
parameter space with Θ. We denote the log likelihood function of the observation at time 𝑡 by
𝑙𝑡 (𝜃). The log likelihood function 𝑙(𝜃) is hence
𝑙(𝜃) = Σ𝑇𝑡=1 𝑙𝑡 (𝜃)
By a direct application of Sklar’s Theorem which enables the seperation of univariate margins
and the dependence structure we have
𝑇 ∑
𝑁
( ) ∑
𝑙(𝜃) = Σ𝑇𝑡=1 = ln 𝑐 𝐹1 (𝑥𝑡1 ), ...., 𝐹𝑁 (𝑥𝑡𝑁 ) + ln 𝑓𝑛 (𝑥𝑡𝑛 ) (1.8)
𝑡=1 𝑛=1
Here 𝑐 denotes the density function of the copula and 𝐹𝑖 (; ) denotes the distribution function
of the marginals and 𝑓 (; ) the density function of the marginals. 𝑥𝑡𝑖 denotes the time series
observation for the 𝑖𝑡ℎ asset. The maximum likelihood estimator is defined as the vector 𝜃ˆ such
that
( )
ˆ
𝜃ˆ = 𝜃1 , ....., 𝜃ˆ𝑘 = arg max {𝑙(𝜃) : 𝜃 ∈ Θ}
The Inference Function for Margins method is based on equation (1.8). It is a two step fitting
proceedure in which one first finds the parameters of the univariate marginals 𝛽 and then the
vector of copula parameters 𝛼.

˜
12
1. At the first stage the EML method is used to find 𝛽 = (𝛽1 , ......, 𝛽𝑛 ) as
𝑇
∑
𝛽ˆ𝑖 = arg max ln 𝑓𝑖 (𝑥𝑡𝑖 ; 𝛽𝑖 )
𝛽𝑡 𝑡=1
( )
2. The copula parameter vector 𝛼 is estimated using 𝛽ˆ = 𝛽ˆ1 , ...., 𝛽ˆ𝑛
𝑇
∑ ( )
ˆ˜ 𝐼𝐹 𝑀 = arg max
𝛼 ln 𝑐 𝐹1 (𝑥𝑡1 ; 𝛽ˆ1 ), ...., 𝐹𝑁 (𝑥𝑡𝑁 ; 𝛽ˆ𝑁 ); 𝛼
˜
𝛼
˜ 𝑡=1
( )
ˆ 𝛼
The IFM estimator is hence 𝛽, ˆ˜ 𝐼𝐹 𝑀 .
13
Chapter 2
Pricing FX Quanto Options in the
Black Scholes Framework
2.1 The standard market practice in pricing FX Quanto Options
In this section we will look at the Black Scholes model used in pricing FX quanto options. Our
currency set is given by 𝐴 = {𝑓, 𝑑, 𝑞}. Here 𝑓 denotes the foreign currency, 𝑑 the domestic
currency and 𝑞 the quanto currency. We take i , j , k ∈ 𝐴 Let us denote by 𝑋𝑡𝑖,𝑗 the exchange
rate between currency i and currency j . We begin with some notations:
𝑖
𝐷𝑡,𝑇 : The time t value in currency i of a zero coupon bond with maturity T
𝑄𝑖 : Equivalent martingale measure associated with the numeraire 𝐷𝑡,𝑇

𝑖
𝑋𝑡𝑖,𝑗 : The value in currency i of one unit of currency j at time t.
K : The strike price of the Quanto FX Option in consideration
14
𝜅 denotes the quanto conversion factor which is predetermined. In all our calculations we will
take this value to be 1.
𝑗
𝑖,𝑗 𝐷𝑡,𝑇 𝑋𝑡𝑖,𝑗
𝑀𝑡,𝑇 = 𝑖
𝐷𝑡,𝑇
is the forward FX rate.
In an arbitrage free economy the following relations hold:
𝑋𝑡𝑖,𝑗 = (𝑋𝑡𝑗,𝑖 )−1
𝑋𝑡𝑘,𝑗
𝑋𝑡𝑖,𝑗 =
𝑋𝑡𝑘,𝑖
Bennett and Kennedy (2003) consider a triangular no arbitrage condition to price FX quanto
options. The numeraire considered will be in the quanto currency. In the pricing formula we
take the risk neutral expectation with respect to the numeraire in the quanto currency. The
payoff of the FX quanto call option is 𝜅[𝑋𝑡𝑖,𝑗 − 𝐾]+ . The price of the FX quanto call option at
initial time:
𝐶0𝑞𝑢𝑎𝑛𝑡𝑜 = 𝜅𝐷0,𝑇
𝑞 𝑞
𝐸𝑄 [𝑋𝑡𝑖,𝑗 − 𝐾]+ (2.1)
𝑞
Here we use 𝑞 because we want to denote that the discount factor 𝐷0,𝑇 and the risk neutral
measure 𝑄𝑞 is with respect to the quanto currency. Hence 𝑖 refers to the foreign currency and
𝑗 to the domestic currency.
2.1.1 Pricing using the Black Scholes Model
We assume that the forward FX rates follow correlated Brownian motions
𝑖,𝑗 𝑖,𝑗
𝑑𝑀𝑡,𝑇 = 𝜎𝑖,𝑗 𝑀𝑡,𝑇 𝑑𝑊𝑡𝑖,𝑗 (2.2)
15
Here 𝜎𝑖𝑗 is the implied volatility of a vanilla FX option on the particular exchange rate with the
particular option parameters as the quanto FX call.
𝑑𝑊𝑡𝑘,𝑖 𝑑𝑊𝑡𝑘,𝑗 = 𝜌𝑑𝑡 (2.3)
2 + 𝜎2 − 𝜎2
𝜎𝑘,𝑖 𝑘,𝑗 𝑖𝑗
𝜌= (2.4)
2𝜎𝑘,𝑖 𝜎𝑘,𝑗
Here 𝜌 is the implied correlation which we recover from the implied volatilities of vanilla FX
options on the particular exchange rate. After evaluating the expectation in equation (2.1)
Bennett and Kennedy (2003) find the price of the quanto FX option under the Black Scholes
Model as
𝐶0𝑞𝑢𝑎𝑛𝑡𝑜 = 𝜅𝐷0,𝑇
𝑘
[𝑀 𝜙(𝑑˜1 ) − 𝐾𝜙(𝑑˜2 )] (2.5)
2
𝑖,𝑗 (𝜎𝑘,𝑖 −𝜌𝜎𝑘,𝑖 𝜎𝑘,𝑗 )𝑇
𝑀 = 𝑀0,𝑇 𝑒
𝑖,𝑗
ln(𝑀0,𝑇 )/𝐾 1 √
𝑑˜1 = √ + 𝜎𝑖,𝑗 𝑇
𝜎𝑖𝑗 𝑇 2
√
𝑑˜2 = 𝑑1 − 𝜎𝑖,𝑗 𝑇
We use equation (2.5) to price FX quanto options under the Black Scholes model in the disser-
tation.
16
Chapter 3
Pricing of FX Quanto under the
Heston Model
The Heston (1993) Stochastic Volatility model relaxes the assumption of constant volatility in the
classical Black Scholes model. An instantaneous short term variance process is incorporated. In
this section we will look at the key aspects adopted while pricing the options under the Heston
stochastic volatility model. However we price our FX quanto options by incorporating jump
processes in the Heston model.
3.1 Revisiting the Heston model
We shortly formalise the model to take care of the notations. The dynamics of the stock process
{𝑆𝑡 , 𝑡 ≥ 0} are given as :

𝑑𝑆𝑡 √
= (𝑟 − 𝑞)𝑑𝑡 + 𝑣𝑡 𝑑𝑊𝑡 𝑆0 ≥ 0 (3.1)
𝑆𝑡
17
The instantaneous variance process 𝑣𝑡 is taken as a mean reverting square root stochastic process
which is also known as Cox Ingersoll Ross (CIR) process. The SDE is given by
√ ˜ 𝑡 𝑣0 = 𝜎02 ≥ 0
𝑑𝑣𝑡 = 𝜅(𝜂 − 𝑣𝑡 )𝑑𝑡 + 𝜆 𝑣𝑡 𝑑𝑊 (3.2)
˜ =𝑊
Here 𝑊 = 𝑊𝑡 where 𝑡 ≥ 0 and 𝑊 ˜ 𝑡 where 𝑡 ≥ 0 are two correlated standard Brownian
motions with correlation 𝜌. The parameters in the equation are: initial volatility, 𝜎0 > 0, mean
reversion rate 𝜅 > 0, the long run variance 𝜂 > 0, the volatility of variance 𝜆 > 0. The variance
is always positive and by the Feller condition it has been shown that it cannot reach zero if
2𝜅𝜂 > 𝜆2 . The variance process 𝑣𝑡 is non centrally Chi-Square distributed.
3.2 Option Pricing under the Heston model
As shown in the Black and Scholes model (Black and Scholes (1973))the value of a derivative
is dependent on the underlying tradeable assets. As the assets are tradeable the option can be
hedged by trading in the underlying. When this happens we say that the market is complete.
This means that every derivative can be replicated.
In the Heston model the price of a derivative would depend on both the randomness of the
asset process (𝑆𝑡 , 𝑡 ≥ 0) and its volatility (𝑉𝑡 , 𝑡 ≥ 0).The volatility is not a tradeable asset and
hence under the Heston model we do not work in a complete market setting. An implication of
this fact to option pricing under the Heston model is that we do not find a unique equivalent
martingale measure (EMM). Under the Heston model, the value of any option 𝑈 (𝑆𝑡 , 𝑉𝑡 , 𝑡, 𝑇 )
18
must satisfy the partial differential equation
1 ∂2𝑈 ∂2𝑈 1 ∂2𝑈 ∂𝑈 √ ∂𝑈 ∂𝑈

𝑉 𝑆 2 2 + 𝜌𝜎𝑉 𝑆 + 𝜎2𝑉 2
+ 𝑟𝑆 + 𝜅[𝜃 − 𝑉 ] − Λ(𝑆, 𝑉, 𝑇 )𝜎 𝑉 − 𝑟𝑈 + =0
2 ∂𝑆 ∂𝑆∂𝑉 2 ∂𝑉 ∂𝑆 ∂𝑉 ∂𝑡
(3.3)
Λ(𝑆, 𝑉, 𝑇 ) is called the market price of volatility risk. In his paper Heston makes the assumption
that the market price of volatility risk is proportional to volatility.
Heston has derived a closed form solution which makes it easier for practitioners to price options
using stochastic volatility. However for our purpose of pricing we will refrain from using the
closed form solution given by Heston. Instead we will use the approach used by Carr and Madan
(1998). Carr and Madan have considered a transformation of the option pricing formulae and
then applied Fourier inversion techniques to compute option prices. We discuss this method as
follows.
3.2.1 The Heston Pricer using Fast Fourier Transform
We consider an asset with value 𝑋𝑡 at time t and an option written on the asset with strike 𝐾.
Let 𝑥𝑡 = ln(𝑋𝑡 ) ; the logarithm of the underlying asset value at time t. For our purpose the
˜ =ln (𝐾); the logarithm of the strike price. Then the

asset is a foreign exchange rate. Let 𝐾
˜ is given by
value of a European Call Option with maturity T as a function of 𝐾
∫ ∞(
˜ = 𝑒−𝑟𝑇 ˜)
𝐶(𝑇, 𝐾) 𝑒𝑥𝑇 − 𝑒𝐾 𝑓𝑇 (𝑥𝑇 )𝑑𝑥𝑇 (3.4)
𝑘
Here 𝑓𝑇 (𝑥) is the risk neutral density of x. 𝑟 denotes the riskfree interest rate. For our FX option
it is the riskfree interest rate in the foreign currency. We observe from the above equation that
˜ tends to the initial spot of the underlying as 𝐾

𝐶(𝑇, 𝐾) ˜ tends to −∞. Hence the call pricing
19
function is not square integrable. As such Carr and Madan modify the call price as
˜
𝐶(𝑇, ˜ = 𝑒𝛼𝑘 𝐶(𝑇, 𝐾)𝑘
𝐾) ˜ ≥0 (3.5)
˜
Carr and Madan then obtain an analytical expression for the Fourier transform of 𝐶(𝑇, ˜ as
𝐾)
∫ ∞
˜˜ ˜
𝜁(𝑢) = 𝑒𝑖𝑢𝑘 𝐶(𝑇, 𝐾)𝑑𝐾. (3.6)
−∞
In terms of the characteristic function 𝜙 of the logarithm of the stock price as
𝑒−(𝑟−𝑞)𝑇 𝜙(𝑢 − (𝛼 + 1)𝑖)

𝜁(𝑢) = . (3.7)
𝛼2 + 𝛼 − 𝑢2 + 𝑖(2𝛼 + 1)𝑢
Here r denotes the risk free rate in foreign currency and q the riskfree rate in the foreign currency.
This is followed by the numerical computation of the call prices using the inverse transform
˜ ∫ ∞
˜ = 𝑒−𝛼𝐾 ˜
𝐶(𝑇, 𝐾) 𝑒−𝑖𝑢𝐾 Ã(𝑢)𝑑𝑢. (3.8)
2𝜋 −∞
The Fast Fourier Transform(FFT) is an efficient algorithm to evaluate summations of the form
2𝜋
𝑃 (𝑒) = Σ𝑗=𝑁
𝑗=1 𝑒
−𝑖 𝑁 (𝑗−1)(𝑒−1)
𝑥(𝑗) (3.9)
Carr and Madan note that (3.8) can be integrated using the FFT algorithm. The FFT algorithm
is as follows
(a) We discretize (3.8) using the Trapezoid Rule and set 𝑢𝑗 = 𝜂(𝑗 − 1). This gives us
˜
˜ ≈ 𝑒−𝛼𝐾 𝑁 −𝑖𝑢𝑗 𝐾𝜁(𝑢
˜ 𝑗 )𝜂
𝐶(𝑇, 𝐾) Σ𝑗=1 𝑒 (3.10)
𝜋
˜ of size 𝜆 to obtain 𝐾
(b) We take a regular grid for 𝐾 ˜ 𝑢 = −𝑏 + 𝜆(𝑠 − 1) for 𝑠 = 1, 2, ...., 𝑁 giving
𝑁𝜆
log strike levels from -b to b where 𝑏 = 2 .
20
(c) We substitute step (b) in step (a) to obtain
−𝛼𝐾˜ 𝑗=𝑁
∑
˜ 𝑢) = 𝑒
𝐶(𝑇, 𝐾
2𝜋 𝜂
𝑒−𝑖 𝑁 (𝑗−1)(𝑠−1) 𝑒𝑖𝑏𝑢𝑗 𝜁(𝑢𝑗 ) (3 + (−1)𝑗 − 𝛿𝑗−1 ). (3.11)
𝜋 3
𝑗=1
Here 𝛿𝑛 is the Kronecker delta function.
(d) Finally we use the FFT to compute the call prices.
Carr and Madan provide the optimum parameter values as 𝑁 = 4096, 𝜂 = 0.25 and 𝛼 = 1.5.
As we see to evaluate 𝜁 we need to use the characteristic function 𝜙 of the logarithm of the
underlying asset.
In the Heston framework we need to take special care while evaluating this characteristic func-
tion.
3.2.2 The Heston Trap
In this section we talk about the use of an alternative characteristic function as given by Al-
brecher et al. (2007). For the log asset price distribution the characteristic function is given
by
[ ]
𝜙(𝑢, 𝑡) = 𝔼 exp(𝑖𝑢 ln(𝑆𝑡 ))∣𝑆0 , 𝜎02 (3.12)
However there are two formulas for the characteristic function. We can find the first formula in
Heston (1993). It is
𝜙1 (𝑢, 𝑡) = exp(𝐴) × exp(𝐵) × exp(𝐶). (3.13)
21
where
𝐴 = 𝑖𝑢(ln 𝑆0 + (𝑟 − 𝑞)𝑡).
and
( ( ))
−2 1 − 𝑔1 𝑒𝑑𝑡
𝐵 = 𝜂𝜅𝜆 (𝜅 − 𝜌𝜆𝑖𝑢 + 𝑑)𝑡 − 2 ln .
1 − 𝑔1
and
( )
𝜎02 𝜆−2 (𝜅 − 𝜌𝜆𝑖𝑢 + 𝑑)(1 − 𝑒𝑑𝑡 )
𝐶= .
1 − 𝑔1 𝑒𝑑𝑡
To explain notations further
√
𝑑= (𝜌𝜆𝑢𝑖 − 𝜅)2 + 𝜆2 (𝑖𝑢 + 𝑢2 ).
𝑔1 = (𝜅 − 𝜌𝜆𝑖𝑢 + 𝑑)/(𝜅 − 𝜌𝜆𝑖𝑢 − 𝑑).
The second one is as discussed in Albrecher et al. (2007).
𝜙2 (𝑢, 𝑡) = exp(𝐴) × exp(𝐷) × exp(𝐸). (3.14)
where
( ( ))
−2 1 − 𝑔1 𝑒−𝑑𝑡
𝐷 = 𝜂𝜅𝜆 (𝜅 − 𝜌𝜆𝑖𝑢 − 𝑑)𝑡 − 2 ln .
1 − 𝑔1
( )
𝜎02 𝜆−2 (𝜅 − 𝜌𝜆𝑖𝑢 + 𝑑)(1 − 𝑒−𝑑𝑡 )
𝐸= .
1 − 𝑔2 𝑒−𝑑𝑡
where
1
𝑔2 = .
𝑔1
22
We note that the difference between 𝐵 and 𝐷 is that we have a negative sign before 𝑑𝑡 in 𝐷 while
a positive sign in 𝐵. Albrecher et al. (2007) have shown that the options are mispriced when
using the value of 𝜙1 in the Carr Madan Formulae for option pricing. Our Heston parameter
space has to be restricted to use 𝜙1 as a characteristic function. However 𝜙2 can be applied to
the whole unrestricted parameter space and is a better choice.
3.3 The Heston model with jumps
One of the primary requisites of option pricing is that we can fit our model prices to the market
smile. While the Heston stochastic variance model fits the long term behaviour of the asset price
it does not adequately describe the short term behaviour as shown by Weron et al. (2004). As
such we extend the Heston stochastic volatility model with jumps in the asset price process as
by Bates (1993) and Bakshi et al. (1993).This model is a jump diffusion model. Carr and Wu
(2004) say that in this model the desired smile is created for short maturities by jumps while at
longer maturities the effect is created by stochastic volatility.
𝑑𝑆𝑡
= (𝑟 − 𝑞 − 𝜆𝜇𝐽 )𝑑𝑡 + 𝜎𝑡 𝑑𝑊𝑡 + 𝐽𝑡 𝑑𝑁𝑡 . (3.15)
𝑆𝑡
Here 𝑁 = {𝑁𝑡 , 𝑡 ≥ 0} is an independent Poisson process with parameter 𝜆 ≥ 0. 𝐽𝑡 is the
percentage jump size which is assumed to be lognormally and identically distributed with time
𝜎𝐽2
and with unconditional mean 𝜇𝐽 . ln(1 + 𝐽𝑡 ) is normally distributed with mean ln(1 + 𝜇𝐽 ) − 2
and variance 𝜎𝐽2 . As far as our pricing methodology goes the only change with the Heston model
would be in the characteristic function. The characteristic function of the Heston with jumps is
actually a product of the characteristic function of Heston 𝜙2 and the characteristic function of
23
the jump process, 𝜙𝐽 . This is given in Schoutens et al. (2005).
𝜙𝐻𝐽
2 (𝑢, 𝑡) = exp(𝐴) × exp(𝐷) × exp(𝐸) × exp(𝐹 ) × exp(𝐺). (3.16)
where
𝐹 = −𝜆𝜇𝐽 𝑖𝑢𝑡 + 𝜆𝑡((1 + 𝜇𝐽 )𝑖𝑢 .
𝐺 = 𝜎𝐽2 (𝑖𝑢/2)((𝑖𝑢 − 1)) − 1).
We can see that
𝜙𝐽 = exp(𝐹 ) × exp(𝐺).
3.4 Pricing the FX Quanto option
Let 𝑋𝑡𝑎,𝑏 denote the exchange rate which follows the asset process in the Heston with jumps
equation. Here 𝑎 denotes the foreign currency and 𝑏 denotes the domestic currency. The price of
a plain vanilla European option with the exchange rate as underlying,strike K, time to maturity
K under an EMM Q is given by
𝐶0𝑣𝑎𝑛𝑖𝑙𝑙𝑎 = 𝑒−𝑟𝑎 𝑇 𝔼𝑄 [𝑋𝑇𝑎,𝑏 − 𝐾]+ (3.17)
Here 𝑟𝑎 denotes the risk free rate in the foreign currency i. The price of an FX quanto option
is given by
𝐶0𝑞𝑢𝑎𝑛𝑡𝑜 = 𝑒−𝑟𝑐 𝑇 𝔼𝑄 [𝑋𝑇𝑎,𝑏 − 𝐾]+ (3.18)
Here 𝑟𝑐 denotes the risk free rate in the quanto currency 𝑐. This is the formulae we will be
using while pricing the FX plain vanilla and the quanto options without a copula. Later we
24
also incorporate a copula. This is discussed in section 5.3. Once the prices of the plain vanilla
options are evaluated we back out the Black Scholes implied volatilities which are then used for
the calibration process. The parameters we get after the calibration of the plain vanilla options
are then used to price the quanto with the copula.
25
Chapter 4
Pricing of FX Quanto under the
GARCH Option Pricing Model
4.1 Duan’s GARCH Option Pricing Model
In this section we will discuss the methodology adopted in pricing the quanto option using the
GARCH Option Pricing Model. This has been developed by Duan (1995). Duan and Wei (1999)
have further extended the GARCH Option Pricing Model for valuation of Foreign Exchange
Options. The conditional variance 𝜎𝑡 follows a non linear asymmetric GARCH(1,1) model. As
before our currency set is given by 𝐴 in section 2.1. Let us denote by 𝑋𝑡𝑖,𝑗 the exchange rate
between currency i and currency j where i,j ∈ 𝐴. The asset process of 𝑋𝑡𝑖,𝑗 is governed by the
probability law ℙ with respect to information filtration 𝔉𝑡 . We take the measure ℙ with respect
to the domestic currency.
26
We have the following process for the exchange rate 𝑋𝑡𝑖,𝑗 .
[ 𝑖,𝑗
]
𝑋𝑡+Δ 1 2
ln = (𝑟𝑓 − 𝑟𝑑 ) + 𝜆𝜎𝑡+Δ − 𝜎𝑡+Δ + 𝜎𝑡+Δ 𝜖𝑡+Δ (4.1)
𝑋𝑡𝑖,𝑗 2
𝜖𝑡+Δ ∼ 𝑁 (0, 1)
under ℙ
2
𝜎𝑡+Δ = 𝛽0 + 𝛽1 𝜎𝑡2 + 𝛽2 𝜎𝑡2 (𝜖𝑡 − 𝜃)2 (4.2)
Here 𝑟𝑓 denotes the foreign risk free rate and 𝑟𝑑 denotes the domestic risk free rate. The
parameter 𝜆 represents the unit risk premium for the exchange rate.The parameter 𝜃 represents
a leverage parameter. The leverage effect in GARCH models comes from the empirical evidence
that increase in volatility is larger when the returns are negative than when they are positive.
Duan (1995) comes to the conclusion that if 𝜃 is positive there is a negative correlation between
2
the innovations of the asset return and its conditional volatility. As we can see 𝜎𝑡+Δ is expressed
in terms of 𝔉𝑡 measurable random variables. The volatility process is hence predictable or known
at time 𝑡.
Under the locally risk neutralized probability measure ℚ the exchange rate dynamics given by
Duan(1995) is
[ 𝑖,𝑗
]
𝑋𝑡+Δ 1 2
ln = (𝑟𝑓 − 𝑟𝑑 ) − 𝜎𝑡+Δ + 𝜎𝑡+Δ 𝜖˜𝑡+1 (4.3)
𝑋𝑡𝑖,𝑗 2
𝜖˜𝑡+1 = 𝜖𝑡+1 + 𝜆 ∼ 𝑁 (0, 1)
under ℚ
2
𝜎𝑡+Δ = 𝛽0 + 𝛽1 𝜎𝑡2 + 𝛽2 𝜎𝑡2 (˜
𝜖𝑡 − 𝜃 − 𝜆)2
The condition for first order stationarity is 𝛽1 + 𝛽2 [1 + (𝜃 + 𝜆)2 ] < 1. Under the risk neutralized
system the volatility remains as an NGARCH process. The leverage parameter here is 𝜃 +
27
𝜆. When we try to fit the prices from the model to market prices we have to calibrate four
parameters. They are 𝛽0 , 𝛽1 , 𝛽2 and 𝜃 + 𝜆.
4.2 Analytical Approximation of the GARCH Option Pricing
Model
Duan et al. (1999) has derived an analytical approximation to the option pricing problem under
GARCH. We give a review of this method in this section. The option price is determined in
( )
𝑋0𝑖,𝑗
terms of the moments of the cummulative asset return 𝜌𝑇 = ln 𝑖,𝑗 . We denote the standard
𝑋𝑇
normal distribution function as 𝑁 and the density function as 𝑛(). The formulae for the price
of a European FX call option with spot price 𝑋0𝑖,𝑗 , strike K, time to maturity T is given as
𝐶𝑎𝑝𝑝𝑟𝑜𝑥 = 𝐶 + 𝜅3 𝐴3 + (𝜅4 − 3)𝐴4 (4.4)
where
˜ − 𝐾𝑒−(𝑟𝑑 −𝑟𝑓 )𝑇 𝑁 (𝑑˜ − 𝜎𝜌 )

𝐶 = 𝑋0𝑖,𝑗 𝜙(𝑑) 𝑇
The constants 𝐴3 , 𝐴4 are given as
1 𝑖,𝑗 [ ]
𝐴3 = ˜ 𝑑)
𝑋0 𝜎𝜌𝑇 (2𝜎𝜌𝑇 − 𝑑)𝑛( ˜ − 𝜎 2 𝑁 (𝑑)
˜
𝜌𝑇
3!
1 𝑖,𝑗 { }
𝐴4 = 𝑋0 𝜎𝜌𝑇 [𝑑˜2 − 1 − 3𝜎𝜌𝑇 (𝑑˜ − 𝜎𝜌𝑇 )]𝑛(𝑑)
˜ + 𝜎 3 𝑁 (𝑑)
𝜌𝑇
˜
4!
with
𝑑˜ = 𝑑 + 𝛿
where ( ) ( )
ln 𝑋0𝑖,𝑗 /𝐾 + (𝑟𝑑 − 𝑟𝑓 )𝑇 + 21 𝜎𝜌2𝑇
𝑑=
𝜎𝜌𝑇
28
and
𝜇𝜌𝑇 − (𝑟𝑑 − 𝑟𝑓 )𝑇 + 21 𝜎𝜌2𝑇
𝛿=
𝜎𝜌𝑇
Here
[ ]
𝜇𝜌𝑇 = 𝔼ℚ
0 𝜌𝑇
and
√ [ ]
𝜎𝜌𝑇 = 𝑉 𝑎𝑟0ℚ 𝜌𝑇
We use 𝔼ℚ
0 to denote conditional expectation under ℚ with respect to 𝔉0 .
𝜅3 and 𝜅4 represent the third and fourth cumulants of the normalized cummulative return 𝑧𝑇
which is given by
𝜌𝑇 − 𝜇𝜌𝑇
𝑧𝑇 =
𝜎𝜌𝑇
We note that
𝑋𝑇𝑖,𝑗 = 𝑋0𝑖,𝑗 exp(𝜇𝜌𝑇 + 𝜎𝜌𝑇 𝑧𝑇 ) (4.5)
The price of an European FX Call option with strike K is given by
[ 𝑖,𝑗 ]
exp(−(𝑟𝑑 − 𝑟𝑓 )𝑇 )𝔼ℚ
0 max(𝑋𝑇 − 𝐾, 0)
Hence
ln 𝑋0𝑖,𝑗
+ 𝜇𝜌𝑇
𝑋𝑇𝑖,𝑗 ≥ 𝐾 ⇔ −𝑧𝑇 ≤ 𝐾 ˜
=𝐾 (4.6)
𝜎𝜌𝑇
Now
[ 𝑖,𝑗 ]
𝔼ℚ
0 max(𝑋𝑇 − 𝐾, 0) = (4.7)
∫ ˜
𝐾 [ ]
𝑖,𝑗
𝑋0 exp(𝜇𝜌𝑇 − 𝜎𝜌𝑇 𝑧) − 𝐾 𝑔(𝑧)𝑑𝑧
−∞
29
To evaluate the above expression we observe from equation (4.5) that we need the true density
function 𝑔(𝑧) of 𝑧𝑇 . Duan et al. (1999) follow the method adopted by Jarrow and Rudd (1982). It
involves the approximation of a probability distribution by an arbitrary distribution.The density
function is expressed in terms of an expansion which involves second and higher order moments
of the arbitrary distribution. In this case the approximation was given as
[ ]
𝜅3 𝜅4 − 3 4
𝑔(𝑧) = 𝑛(𝑧) 1 − (𝑧 3 − 3𝑧) + (𝑧 − 6𝑧 2 + 3) (4.8)
3! 4!
With this approximation Duan et al. (1999) uses equation (4.7) to evaluate the price of the
option. Equation (4.4) gives the approximated price of the option after the approximation.
Duan et al. (1999) have also provided explicit expressions for 𝜇𝜌𝑇 ,𝜎𝜌𝑇 , 𝜅3 and 𝜅4 in terms of the
parameters involved in the NGARCH volatility process which enables the computation of the
option prices.
30
Chapter 5
Modelling the Dependence Structure
Using a Copula
The previous two sections spoke about pricing the FX quanto option using the Heston Model
and the GARCH Option Pricing Model. Let us denote by 𝑋𝑡𝑖,𝑗 the exchange rate with i as the
foreign currency and j as the domestic currency. By principle of no arbitrage we can say
𝑋𝑡𝑘,𝑗
𝑋𝑡𝑖,𝑗 = (5.1)
𝑋𝑡𝑘,𝑖
The payoff of the FX quanto option with 𝑋𝑡𝑖,𝑗 as underlying, maturity T , strike K is given by
[ ]
𝑋𝑡𝑘,𝑗
𝑃𝑇𝑞𝑢𝑎𝑛𝑡𝑜 = 𝑚𝑎𝑥 − 𝐾, 0 (5.2)
𝑋𝑡𝑘,𝑖
Such an approach could be useful if for instance 𝑋𝑡𝑖,𝑗 was a less frequently traded, illiquid asset.
And both 𝑋𝑡𝑘,𝑗 and 𝑋𝑡𝑘,𝑖 were more liquid in the market as compared to the original currency. In
the context of our pricing problem there is another motivation for doing so. In the Black model
31
the implied volatility quote of a quanto on an exchange rate, take for instance the USD/JPY
exchange rate depends on the implied volatilities of the EUR/USD and the EUR/JPY rates.
Here EUR is the quanto currency. Since the forward rate and the exchange rate process is linked
only by a scaler factor we can say that the volatility of the USD/JPY rate is influenced by the
EUR/USD and the EUR/JPY rates. We have not accounted for this in the GARCH or Heston
model with jumps to price the FX quanto option. We need to model the dependence structure
of the EUR/USD and the EUR/JPY rates. One way of doing this could be by using a copula.
The marginals are free to be chosen depending on the calibration of plain vanilla quotes.
We can now view the FX quanto option as a multivariate contingent claim. In such a situation
it is valid to think that the payoff of the option would depend on the co-movement between the
two exchange rate returns. We will use a copula to measure the association between the two
assets.We can use a wide choice of dependent structures using a copula, for instance linear, non
linear or tail dependent.
We will formalise the definition of a copula. This is given in Frees and Valdez (1977).
Let us consider p uniform random variables 𝑢1 , 𝑢2 , ...., 𝑢𝑝 . We need not assume that they are inde-
pendent. The dependence relationship is given by a joint distribution function 𝐶(𝑢1 , 𝑢2 , ..., 𝑢𝑝 ) =
𝑃 𝑟𝑜𝑏(𝑈1 ≤ 𝑢1 , 𝑈2 ≤ 𝑢2 , ...., 𝑈𝑝 ≤ 𝑢𝑝) )
We select arbitrary marginal distribution functions 𝐹1 (𝑥1 ), 𝐹2 (𝑥2 ), ...., 𝐹𝑝 (𝑥𝑝 ). Then the function
[ ] ( )
𝐶 𝐹1 (𝑥1 ), 𝐹2 (𝑥2 ), ...., 𝐹𝑝 (𝑥𝑝 ) = 𝐹 𝑥1 , 𝑥2 , ...., 𝑥𝑝 (5.3)
defines a multivariate distribution function evaluated at 𝑥1 , 𝑥2 , ...., 𝑥𝑝 with marginal distributions
𝐹1 , 𝐹2 , 𝐹3 ..., 𝐹𝑝 . We call the function C a copula.
32
In our case of modelling the dependence between the exchange rates we will use the T-copula
from the Elliptic distribution and a copula from the Archimedean family. Archimedean copulas
are simpler to apply. It allows us to reduce the study of a multivariate copula to a single
univariate family.
5.1 Archimedean Copulas
We first formalise the definition of Archimedean copulas.
Definition 5.1. Let 𝜙 be a convex, decreasing function with with domain (0, 1] and range [0, ∞)
such that 𝜙(1) = 0. Then the function 𝐶𝜙 (𝑢, 𝑣) = 𝜙−1 (𝜙(𝑢) + 𝜙(𝑣)) for u,v ∈ (0, 1] is said to be
an Archimedean Copula. 𝜙 is called the generator of the copula.
It is worthwhile to mention that a generator uniquely determines an Archimedean Copula. We
give below a table of Archimedean Copulas and their generators in table 5.1.
Family Generator 𝜙(𝑡) Domain(𝛼) 𝐶𝜙 (𝑢, 𝑣)
Clayton 𝑡−𝛼 − 1 𝛼>1 (𝑢−𝛼 + 𝑣 −𝛼 − 1)−1/𝛼

( )𝛼 { [( )𝛼 ( )𝛼 ]1/𝛼 }
Gumbel − ln 𝑡 𝛼≥1 exp - -ln 𝑢 + − ln 𝑣
𝛼𝑡 ( (𝑒𝛼𝑢 −1)(𝑒𝛼𝑣 −1) )
Frank 𝑙𝑛 𝑒𝑒𝛼 −1
−1
−∞ < 𝛼 < ∞ 1
𝛼 ln 1 + 𝑒𝛼 −1
Table 5.1: Archimedean Copulas and their Generators
5.1.1 Archimedean Copulas and their Measures of Dependence
There is an important result due to Schweizer and Wolf (1981). They have established that if
𝑓1 and 𝑓2 were strictly increasing but arbitrary functions over the range of the random variables
33
𝑋1 , 𝑋2 then 𝑓1 (𝑋1 ) and 𝑓2 (𝑋2 ) have the same copula as 𝑋1 and 𝑋2 . This ensures that the
co-movement between the two random variables 𝑋1 , 𝑋2 is captured by the copula. Schweizer
and Wolf (1981)have also shown that two standard non parametric correlation measures, the
Spearman’s Rank Correlation and the Kendall’s correlation coefficient can be expressed in terms
of the copula function.
The first one is the Spearman’s Rank Correlation Co-efficient defined as
∫ ∫
{ }
𝜌(𝑋1 , 𝑋2 ) = 12 𝐶(𝑢, 𝑣) − 𝑢𝑣 𝑑𝑢𝑑𝑣
The second one is the Kendall’s correlation coefficient defined by
∫ ∫
𝜏 (𝑋1 , 𝑋2 ) = 4 𝐶(𝑢, 𝑣)𝑑𝐶(𝑢, 𝑣) − 1
For the Archimedean copula family both the Spearman’s Rho and Kendall Tau correlation can
be expressed in terms of the parameter 𝛼. This is summarised in the table 5.2.
Family Kendall’s 𝜏 Spearman’s 𝜌
𝛼
Clayton 𝛼+2 No closed form
Gumbel 1 − 𝛼−1 No closed form
Frank 1 − 𝛼4 {𝐷1 (−𝛼) − 1} 1− 12

𝛼 {𝐷2 (−𝛼) − 𝐷1 (−𝛼)}
Table 5.2: Archimedean Copulas and Measures of Dependence
where for the Frank Copula we have
∫ 𝑥
𝑘 𝑡𝑘
𝐷𝑘 (𝑥) = 𝑑𝑡
𝑥𝑘 0 𝑒𝑡 − 1
𝑘𝑥
𝐷𝑘 (−𝑥) = 𝐷𝑘 (𝑥) +
𝑥+1
34
5.1.2 Identifying the Right Copula from the Archimedean Family to Model
the Dependence
We will use the proceedure used by Genest and Rivest (1993) to identify the right copula to
model the dependence structure between the two exchange rates. We start with a bivariate set of
{ }𝑛
observations (𝑋1𝑖 , 𝑌2𝑖 ) 𝑖=1 which in our case are the log returns of exchange rate. We assume
that the distribution function F of the bivariate data has an associated Archimedean Copula
𝐶𝜙 . Let 𝑍𝑖 = 𝐹 (𝑋1𝑖 , 𝑋2𝑖 ) be a random variable which has the distribution function 𝐾(𝑧) =
Prob(𝑍𝑖 ≤ 𝑧). It can be proved that the distribution function is related to the generator of an
Archimedean copula through the expression
𝜙(𝑡)
𝐾 =𝑡−
𝜙′ (𝑡)
The following steps are taken to find 𝜙. This is the method followed by Genest and Rivest
(1993).
1. The Kendall correlation coefficient is estimated using the historical bivariate exchange rate
data. This is given as

∑ [ ]
𝜏𝑛 = 𝑠𝑔𝑛 (𝑋1𝑖 − 𝑋1𝑗 )(𝑋2𝑖 − 𝑋2𝑗 ) (5.4)
𝑖<𝑗
2. A non parametric estimate of K is constructed as follows:
a. We first define the observations as 𝑍𝑖 = number of (𝑋1𝑗 , 𝑋2𝑗 ) such that 𝑋1𝑗 < 𝑋1𝑖 and
𝑋2𝑗 < 𝑋2𝑖 /(𝑛 − 1) for 𝑖 = 1, ......𝑛.
b. We now construct the estimate of K as 𝐾𝑛 (𝑧) = proportion of 𝑍𝑖′ 𝑠 ≤ 𝑧
35
3. We now construct a parametric estimate of K using
𝜙(𝑧)
𝐾𝜙 (𝑧) = 𝑡 −
𝜙′ (𝑧)
We select 𝜙 and hence the particular copula from the Archimedean family such that the para-
metric estimate most closely resembles the non parametric estimate. We choose the copula for
what the value of 𝑑 is the lowest where 𝑑 is given by
∫
[ ]
𝑑= 𝐾𝜙𝑛 (𝑧) − 𝐾𝑛 (𝑧) 𝑑𝐾𝑛 (𝑧) (5.5)
Once we know the copula to choose we will proceed by first finding the Kendall Tau Rank
Correlation from the historical data. The parameter of the copula 𝛼 is then estimated from the
Kendall Tau Rank Correlation from Table 5.2.
Our copula fititng technique is based on the historical spot exchange rate data. The use of a
member of the Archimedean Copula Family simplifies the fitting procedure a lot. Apart from
the independent copula we have three classes of members of the Archimedean family which have
distinct forms of the generator function. We have covered all three families by picking one from
each. The Frank, Gumbel and Clayton copulas belong to three distinct Archimedean families.
These three copulas can model various kinds of dependencies. The Clayton Copula exhibits
greater negative tail dependence than positive dependency. The Gumbel Copula on the other
hand exhibits more positive dependence than negative. The Frank Copula is symmetric. It has
lighter tails than a Normal Distribution. We generate a copula from the Archimedean family
with the proceedure given by Nelsen (2006). This is shown in Figures 5.1,5.2 and 5.3.
36
Random sample from Frank Copula Random sample from Clayton Copula
1 1
0.8 0.8
0.6 0.6
v
v
0.4 0.4
0.2 0.2
0 0
0 0.2 0.4 0.6 0.8 1 0 0.2 0.4 0.6 0.8 1
u u
Figure 5.1: Frank Copula with 𝛼 = 1.5 Figure 5.2: Clayton Copula with 𝛼 = 1.5
Random Sample from Gumbel Copula
1
0.8
0.6
v
0.4
0.2
0
0 0.2 0.4 0.6 0.8 1
u
Figure 5.3: Gumbel Copula with 𝛼 = 1.5
5.2 The T Copula
We begin by formalising the definition of the T Copula
Definition 5.2. Let R be a symmetric, positive definite matrix with diag (R)= 1. Let 𝑇𝑅,𝜈 be
the standardized multivariate Student’s t distribution with correlation matrix 𝑅 and 𝜈 degrees
of freedom. Then the multivariate Student’s t copula is defined as 𝐶(𝑢1 , 𝑢2 , ......, 𝑢𝑛 ; 𝑅, 𝜈) =

( )
𝑇𝑅,𝜈 𝑡−1 −1 −1 −1
𝜈 (𝑢1 ), 𝑡𝜈 (𝑢2 ), ....., 𝑡𝜈 (𝑢𝑛 ) Here 𝑡𝜈 (𝑢) denotes the inverse of the Student’s t cumulative
distribution function.
37
5.2.1 Calibration of the T Copula
Mashal and Zeevi(2002) have shown that the empirical fit of a T Copula is better than a
Gaussian copula. Financial data sometimes have heavy tails. Log returns of exchange rates we
have taken have high kurtosis of 9. Mashal and Zeevi(2002) say that a T Copula captures better
dependent extreme values. In the copula function the choice of marginals and the dependency
structure is independent. In the T Copula we estimate the correlation matrix 𝑅 and the degrees
of freedom 𝜈. The methodology we will adopt to calibrate the T Copula to the log returns of
the spot exchange rates is due to Mashal and Zeevi (2002). In this method there is no prior
assumption on the distribution form of the marginals. It is a Canonical Maximum Likelihood
Estimate(CML) method. We take the observation vector (of historical log returns of exchange
rates)𝑋 = (𝑋1𝑡 , 𝑋2𝑡 , .....𝑋𝑁 𝑡 )𝑇𝑡=1 and and approximate the parametric marginals 𝐹𝑛ˆ(.) as
𝑇
1∑
𝐹𝑛ˆ(𝑥) = 1{𝑋𝑛𝑡≤𝑥 }
𝑇
𝑡=1
We first give a result due to Lindskog et al. (2001).
∑
Theorem 5.3. Let 𝑋 ∼ 𝐸𝑁 (𝜈, ) where for i,j 𝜖{1, 2, ...., 𝑁 }, 𝑋𝑖 and 𝑋𝑗 are continuous. Then,
2
Γ(𝑋𝑖 , 𝑋𝑗 ) = 𝑎𝑟𝑐𝑠𝑖𝑛𝑅𝑖,𝑗 (5.6)
𝜋
∑ ∑
where 𝐸𝑁 (𝜈, ) denotes the N-dimensional elliptical distribution with parameters (𝜈, ). Γ(𝑋𝑖 , 𝑋𝑗 )
and 𝑅𝑖,𝑗 denote the Kendall’s Tau and Pearson’s linear correlation coefficient for the random
variables (𝑋𝑖 , 𝑋𝑗 ).
The procedure we adopt to calibrate the T Copula is as follows
38
1. We start with a historical sample X of the exchange rate data. We then transform the initial
data set into a set of uniform variates 𝑈 using an empirical marginal transformation. Given the
data set we use the empirical marginal distribution. For 𝑡 = 1, ......, 𝑇 let
[ ˆ ]
𝑢ˆ𝑡 = (𝑢ˆ𝑡1 , 𝑢ˆ𝑡2 , 𝑢ˆ𝑡𝑁 ) = 𝐹1 (𝑋 ˆ
1𝑡 ), ...., 𝐹𝑁 (𝑋𝑁 𝑡 )
2. We use equation 5.6 to estimate the correlation matrix 𝑅𝐶𝑀 𝐿 .
3. We then find the estimate 𝜈˜ of the degrees of freedom by maximizing the log likelihood
function of the Student’s t-copula density.
𝜈˜ = arg maxΣ𝑇𝑡=1 ln 𝑐𝑠𝑡𝑢𝑑𝑒𝑛𝑡 (𝑢ˆ𝑡1 , 𝑢ˆ𝑡2 , ...., 𝑢ˆ𝑡𝑁 ; 𝑅𝐶𝑀 𝐿 , 𝜈)

𝜈∈Θ
5.3 Pricing using the copula
We use a Monte Carlo simulation to price options with the copula. Let us denote the number
of samples as 𝑀 and the number of timesteps as 𝑚.We generate pairs (𝑢𝑖 , 𝑣𝑖 ) from the copula
where 𝑖 = 1, 2, ...., 𝑚. We take the marginals which are exchange rates to follow the Heston
𝑇
with jumps process as discussed in Section 3.0.6. We denote Δ𝑡 = 𝑚 where T denotes the
time to maturity of the option.The Brownian motions (𝑑𝑊𝑡1 , 𝑑𝑊𝑡2 ) driving each of the marginal
processes are constructed as follows
√
𝑑𝑊𝑡1 = 𝑁 −1 (𝑢𝑖 ) Δ𝑡
√
𝑑𝑊𝑡2 = 𝑁 −1 (𝑣𝑖 ) Δ𝑡
39
Here 𝑁 denotes the distribution function of a standard normal random variable. We also know
that the Brownian motions driving the variance process and asset process for the first exchange
rate have a correlation 𝜌 (which we obtain from the calibration of the marginals). We construct
the Brownian motion for the variance process as
√
˜ 𝑡1 = 𝑥𝑖 Δ𝑡
𝑑𝑊
where
√
𝑥𝑖 = 𝑁 −1 (𝑢𝑖 )𝜌 + 1 − 𝜌2 𝑁 −1 (𝑎𝑖 )
Here 𝑎𝑖 is the third uniform variate which is chosen independently from the first two. The first
two 𝑢𝑖 and 𝑣𝑖 are generated from the copula.
We follow the same procedure for the second exchange rate as well. In this way we simulate the
asset process and the variance process. The price of the FX Quanto option is evaluated by the
usual procedure followed in a Monte Carlo.
40
Chapter 6
Data
6.1 Discount Factors, Implied Volatility quotes
In this section we will present the data which will be used to price the FX quanto options. We
have obtained the data from Bennett and Kennedy (2003) The source of data in the paper is
Meryll Lynch United Kingdom. The data comprises of
a. The discount factors of three currencies - United States Dollar (USD), Euros(EUR) and
Japanese Yen(JPY) pertaining to maturities of 1 month, 3 months, 6 months, 1 year and 2 year
as on 7 July 2001. Hence we price our options on 7 July 2001.
b. The implied volatilities of plain vanilla FX options written on EUR/USD, EUR/JPY and
USD/JPY exchange rates on 7 July 2001. The implied volatilities are given in terms of the
Black Delta (Δ) of the option.
41
Maturity EUR USD JPY
1/12 0.996243 0.996661 0.999948
1/4 0.988734 0.990054 0.999805
1/2 0.978343 0.980503 0.999566
1 0.958074 0.959798 0.998965
2 0.916243 0.911070 0.997404
𝑖
Table 6.1: Discount factors 𝐷0,𝑇 corresponding to currency i and maturity T
Maturity 90%(Δ) 80%(Δ) 50%(Δ) 20%(Δ) 10%(Δ)
1/12 0.1289 0.123 0.1215 0.126 0.134
1/4 0.1277 0.121 0.119 0.1235 0.1319
1/2 0.1272 0.1203 0.118 0.1223 0.1305
1 0.1269 0.1196 0.117 0.1216 0.1303
2 0.1249 0.1176 0.115 0.1196 0.1283
Table 6.2: EUR/USD implied volatility quotes of call options corresponding to standard values
of Black Delta and maturity T
6.2 Recovering Strikes and Prices of FX vanilla options
For calibration of plain vanilla FX options we need to price options using a particular model.
For this purpose we need to recover strikes (K)for FX call options from the implied volatility
quotes. We use the formulae given by Carr and Wu (2004).
[ ]
1 2 √ −1 𝑟 𝑇 Δ
𝐾 = 𝐹 exp 𝜎 𝑇 − 𝜎 𝑇 𝜙 (𝑒 𝑓
)
2
42
Maturity 90%(Δ) 80%(Δ) 50%(Δ) 20%(Δ) 10%(Δ)
1/12 0.1467 0.1441 0.148 0.1606 0.1747
1/4 0.1466 0.1372 0.1385 0.1487 0.1667
1/2 0.1444 0.1329 0.132 0.1414 0.1597
1 0.1443 0.132 0.13 0.138 0.1557
2 0.1508 0.1358 0.1308 0.1358 0.1508
Table 6.3: EUR/JPY implied volatility quotes of call options corresponding to standard values
Maturity 90%(Δ) 80% (Δ) 50%(Δ) 20%(Δ) 10%(Δ)
1/12 0.1109 0.1015 0.095 0.0945 0.099
1/4 0.1156 0.1045 0.0985 0.0995 0.1066
1/2 0.1178 0.1055 0.1 0.1024 0.1122
1 0.1186 0.1065 0.101 0.1048 0.1166
2 0.1235 0.1105 0.106 0.1105 0.1235
Table 6.4: USD/JPY implied volatility quotes of call options corresponding to standard values
where
𝐹 = 𝑋0𝑖,𝑗 𝑒(𝑟𝑑 −𝑟𝑓 )𝑇
Here 𝜙 denote the distribution function of a standard normal variable, 𝑋0𝑖,𝑗 denotes the spot
exchange rate,𝑟𝑑 the domestic risk free interest rate, 𝑟𝑓 the foreign risk free interest rate, T the
time to maturity and 𝜎 the implied volatility quote.
43
We price an FX plain vanilla FX call option using the following formulae used by Carr and Wu
(2004).We will use this when we have to calculate implied volatility using the bisection method.
This will be discussed in Chapter 7.
𝐶0𝑣𝑎𝑛𝑖𝑙𝑙𝑎 = 𝑒𝑟𝑓 𝑇 𝑋0𝑖,𝑗 𝜙(𝑑+ ) − 𝑒𝑟𝑑 𝑇 𝐾𝜙(𝑑− ) (6.1)
where
𝑙𝑛(𝐹/𝐾) 1 √
𝑑+ = √ + 𝜎 𝑇
𝜎 𝑇 2
𝑙𝑛(𝐹/𝐾) 1 √
𝑑− = √ − 𝜎 𝑇
𝜎 𝑇 2
44
Chapter 7
Implementation of Pricing Methods
In this section we will look at pricing the FX quanto option under two different models-the
Heston model with jumps (HJ) and the GARCH Option Pricing Model with the analytical
approximation.
7.1 Implementation of the Heston Stochastic Volatility Model
with Jumps
7.1.1 Calibration of the Model
Before pricing the FX quanto option we would like to fit our pricing model to the market implied
volatilities. Carr and Wu (2004) have carried out an analysis on the suitability of the Heston
model to fit the market smile. They find that for extremely short and longer maturities the
Heston model does not give a good fit. They say that the Heston model with jumps fits the
45
market smile better. We will look to model the dynamics of the USD/JPY exchange rate with
the Heston with jumps model. As we mentioned in the data section we intend to price the
options as on 7 July 2001. Before proceeding to applying a model we take a look at the pattern
of the historical spot USD/JPY exchange rate. We download data of the spot rates from 1
January 1998 to 7 July 2001 (from Datastream)

−3 Time series plot of USD/JPY Exchange Rate
x 10
10
9.5
9
USD/JPY Exchange Rate
8.5
7.5
6.5
0 200 400 600 800 1000 1200
Observations
Figure 7.1: Time series observations of USD/JPY spot exchange rate
Before we price a FX quanto option on an exchange rate we will look to calibrate plain vanilla FX
options. The purpose of our calibration is to obtain values of parameters of the Heston Model
with jumps that accurately describes current market implied volatilities. There is a reason why
we choose to calibrate with market implied volatilities (or market prices of options)of the option
instead of the asset prices of the underlying. If we calibrate to asset prices we obtain parameters
which correspond to the true process of the asset and not the risk neutral process. We would
the need to calculate the market risk premium associated with exposure to volatility changes by
estimating returns on options that are being used to hedge against volatility.
We take up the pricing of vanilla FX options on the USD/JPY rate (please refer to Data for all
46
values).In the calibration process we minimize the least squares error function given by
˜ 𝑖 )2𝑃
𝑀 𝑖𝑛(𝐸𝑟𝑟𝑜𝑟) = Σ𝑛𝑖=1 (𝑋𝑖 − 𝑋
˜ denote market and model implied volatilities and 𝑃 denotes the parameter
where 𝑋 and 𝑋
vector. The parameters involved in the Heston model with jumps are are 𝜎0 , the initial volatility,
𝜅, the mean reversion rate of volatility, 𝜂 the long run variance,𝜆 the volatility of volatility, 𝜃,the
frequency of jumps in a year, 𝜇 the percentage size of the jump and 𝜎𝐽 the variance of the jump
process and 𝜌, the correlation between the Brownian motions driving the asset price process and
the variance process. The constraint
2𝜅𝜂 > 𝜃2
is imposed to ensure that the variance is always positive. We see that the calibration problem for
the Heston model with jumps is thus a general non linear optimization problem. We calibrate to
all maturities using an in-built function called fminsesarch in MATLAB. This function uses the
Nelder and Mead (1965) Algorithm which is an unconstrained non linear optimization algorithm.
Here we add the constraints externally. We set the error function to a very high number if the
constraints are violated. Since fminsearch is a local optimization algorithm we have to take care
while choosing the initial parameters We choose the same values of parameters as by Schoutens
et al. (2005) while pricing options using the Heston with jumps model.
(a) 𝜎0 = 0.05
(b) 𝜅 = 0.5
(c) 𝜂 = 0.06
47
(d) 𝜆 = 0.22
(e) 𝜌 = -0.9
(f) 𝜃 = 0.13
(g) 𝜇 = 0.17
(h) 𝜎𝐽 = 0.13
After the calibration we obtain the following results of the optimum parameters.
Parameter Value
𝜎0 0.1182
𝜅 1.5288
𝜂 0.0481
𝜆 0.3705
𝜌 -0.8102
𝜃 0.120
𝜇 0.005
𝜎𝐽 0.01137
Table 7.1: Parameters of Heston with jumps calibration on USD/JPY rates
The Carr Madan formula with the FFT pricer is most effective for ATM options. Hence we
would expect that the relative error between OTM model and market volatilities is higher. For
options which are in the money region we expect more accurate results.We have checked our
pricer using the Carr Madan formula with the results given by Schoutens et al. (2005).
48
In the calibration excercise we vary the number of iterations from 50 to 2000. We observe that
the parameters converge to the optimum in approximately 1000 iterations.
We would like our model results to be coherent with the market. This can be examined by
comparing the market smile with the smile obtained from our model. We obtained our prices
from the Heston with Jumps model and then inverted them to get the implied volatilities during
the calibration proceedure.
7.1.2 Finding Implied Volatility
During our calibration process we obtain call prices from our Heston with jumps model. To find
the corresponding implied volatility we need to invert the Black Scholes equation. In the Black
Scholes case there is no analytic solution for the Implied Volatility. Instead one has to use a
numerical proceedure or approximation.In our case we use the bisection method to back out the
implied volatilities.The bisection method relies on the fact that option prices increase when the
volatility increases.
The fits to the market smile are given in Figures 7.2 - 7.6 for varying maturities.
We do a piecewise linear interpolation to construct both the volatility surface of the Heston
model with jumps and the market volatility surface for USD/JPY quotes.We observe from the
surface of Heston with jumps (Figure 7.8) that as the delta of the option increases from 0
to 0.50 (roughly in the money region) the implied volatility decreases. As we go from at the
money region to the out of money regions the implied volatility increases. This is similar to the
behaviour of the market implied volatilities (Figure 7.7).
49
Market and model volatilities for USD/JPY FX options with maturity 1 month
Heston with jumps volatility

0.13
Market volatility
0.12
Volatility
0.11
0.1
0.09
0.08
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Delta
Figure 7.2: Market and model volatility(in %) for USD/YEN call options with maturity 1
months
Market and model volatilities for USD/JPY FX options with maturity 3 months
0.13 Heston with jumps Volatility

Market Volatility
0.12
Volatility
0.11
0.1
0.09
0.08
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Delta
months
7.2 Implementation of the GARCH Option Pricing Model
Our aim is to price the FX quanto options with USD/JPY exchange rate as underlying using
the GARCH Option Pricing Model with a Monte Carlo simulation. We first calibrate to the
implied volatility quotes on the USD/JPY rates. In the calibration proceedure we use the same
50
Market and model volatilities for USD/JPY FX options with maturity 6 months

Market Volatility
0.12
Volatility
0.11
0.1
0.09
0.08
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Delta
months
Market and model volatilities for USD/JPY FX options with maturity 1 year

Market Volatility
0.12
Volatility
0.11
0.1
0.09
0.08
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Delta
months
set of innovations during each optimisation step. We calibrate to all maturities. The use of
the GARCH Option Pricing Model in pricing the quanto would be justifiable if we can fit the
market smile using this model.
We follow the same optimisation technique as in the calibration of the Heston model with
51
Market and model volatilities for USD/JPY FX options with maturity 2 years
Heston with jumps Volatility

0.13
Market Volatility
0.12
Volatility
0.11
0.1
0.09
0.08
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Delta
months
jumps.The parameters we have to calibrate are 𝛽0 , 𝛽1 , 𝛽2 and 𝜃 + 𝜆.
Duan (1996) had fit this model to the market smile with the help of a Monte Carlo simula-
tion.Duan et al. (1999) have shown that the difference between the Monte Carlo price and the
analytical approximation is very low. The analytical approximation is considered to be precise
by the authors. Our Monte Carlo was computationally very extensive. It would have been better
to use the analytical approximation. Our choice of initial parameters is based on a parameter
set used by Duan et al. (1999) to price options.
(a) 𝛽0 = 1E-5.
(b) 𝛽1 = 0.1.
(c) 𝛽2 = 0.7
(d) 𝜃 + 𝜆 =0.5
After the calibration we obtain the following results of the optimum parameters as shown in
52
Heston with Jumps Volatility Surface
Market Volatility Surface 0.14
Implied Volatility
0.12
0.14
0.13 0.1
Implied Volatility
0.12
0.08
0.11 2
0.1
1.5
0.09
2 1
0.7
1.5 0.5 0.6
0.5
0.4
Time to Matutity 0.3
1 0 0.2
0.1 Delta
0.8
0.5 0.7
0.6
0.5
0.4
Time to Matutity 0.3
0 0.2
0.1
Delta
Figure 7.8: Heston with Jumps Implied
Figure 7.7: Market Implied Volatility Surface Volatility Surface
Table 7.2.
Parameter Value
𝛽0 1.23E-5
𝛽1 0.231
𝛽2 0.859
𝜃+𝜆 0.935
Table 7.2: Parameters of GARCH calibration on USD/JPY rates
7.2.1 Calibration Results
Finally the values of the implied volatilities obtained from the GARCH Model, Heston Model
with Jumps (HJ) as compared to the market volatilities are given in Tables 7.3- 7.7. We observe
that the volatility we obtain from the GARCH model does not behave in similar way to the
53
market. Actually the behaviour is somewhat opposite to the market. Duan (1996) has fit the
same model to FTSE 100 index options. It could be the case that for this particular set of data
the GARCH model was not well applicable. However our Heston with jumps model fits the
market behaviour a lot better.
Delta Market volatility GARCH volatility HJ volatiltiy
0.10 0.0990 0.0959 0.1044
0.20 0.0945 0.1078 0.0934
0.5 0.095 0.1221 0.0950
0.8 0.1015 0.1286 0.1004
0.9 0.1109 0.1242 0.1036
Table 7.3: Implied volatilities for maturity of 1 month
0.10 0.1066 0.0907 0.1088
0.20 0.0995 0.1068 0.0997
0.50 0.0985 0.1248 0.1015
0.80 0.1045 0.1306 0.1069
0.90 0.1156 0.1185 0.1086
Table 7.4: Implied volatilities for maturity of 3 months
54
0.10 0.1122 0.0989 0.1153
0.20 0.1024 0.1153 0.1098
0.50 0.1 0.1320 0.1123
0.80 0.1055 0.1343 0.1168
0.90 0.1178 0.1102 0.1191
Table 7.5: Implied volatilities for maturity of 6 months
0.10 0.1166 0.1124 0.1168
0.20 0.1048 0.1266 0.1126
0.50 0.101 0.1380 0.1162
0.80 0.1065 0.1299 0.1209
Table 7.6: Implied volatilities for maturity of 1 year
0.10 0.1235 0.1211 0.1082
0.20 0.1105 0.1295 0.0971
0.50 0.106 0.1288 0.102
0.80 0.1105 0.1310 0.1114
0.90 0.1235 0.1342 0.1243
Table 7.7: Implied volatilities for maturity of 2 years
55
7.3 Choosing a model to price the Quanto option
We obtain the Root Mean Squared Errors (RMSE) for the GARCH and the HJ model for the
implied volatility fits.The RSME is defined as

√∑
(Market volatility − Model volatility)2
RSME =
Number of options
Method RMSE
GARCH 0.31
HJ 0.089
Table 7.8: Root mean squared errors for the implied volatility fits on USD/JPY FX rate
We can observe from table 7.8 that the error for the HJ model is substantially lower. We can
say that the HJ model would suit our purpose of pricing the FX quanto option better. However
we price the quanto option using both the models.
7.4 Results of pricing the quanto option
We now proceed to price the FX quanto option on the USD/JPY underlying with EUR as the
quanto currency. We denote the Heston model with jumps price as HJ Quanto,the GARCH
option pricing model price as the GARCH price and the Black Scholes price as BS Quanto.The
prices are in tables 7.9, 7.10, 7.11,7.12 and 7.13. Relative difference (RD) of the HJ model as
compared to the Black Scholes model is calculated as
RD = (Black Scholes Price-Model Price)/(Black Scholes Price).
56
A negative value of the relative difference would mean that the price under stochastic volatility
is more than under constant volatility and vice versa.
Strikes BS Quanto HJ Quanto GARCH Quanto Rel.difference(HJ) Rel.difference(GARCH)
0.00864 1.12E-05 1.65E-05 9.88E-06 -47.95% 11.81%
0.00852 2.52E-05 3.58E-05 3.45E-05 -42.31% -40%
0.00833 9.01E-05 1.05E-04 1.15E-04 -16.49% -28.5%
0.00812 2.28E-04 2.30E-04 2.48E-04 -1.57% -8.39%
0.00798 3.47E-04 3.39E-04 3.53E-04 2.18% -1.7%
Table 7.9: Quanto prices for maturity of 1 month. Spot price is 0.0083 dollars. All the prices
are in the Euro currency.Strike prices in dollars.
0.0089 2.09E-05 2.105E-05 1.08E-05 -0.56% 48.44%
0.00868 4.60E-05 5.20E-05 5.48E-05 -12.72% -19.17%
0.00832 1.61E-04 1.75E-04 2.05E-04 -8.158% -27.03%
0.00796 4.07E-04 4.04E-04 4.39E-04 0.79% -8.01%
0.00771 6.2E-04 6.04E-04 6.30E-04 3.71% -7.36%
Table 7.10: Quanto prices for maturity of 3 months.Spot price is 0.0083 dollars. All the prices
57
0.00923 3.13E-05 2.61E-05 1.88E-05 16.653% 39.78%
0.00885 6.73E-05 7.09E-05 8.98E-05 -5.17% -33.52%
0.00832 2.33E-04 2.49E-04 3.08E-04 -6.81% -32.39%
0.00780 5.84E-04 5.83E-04 6.35E-04 0.74% -8.7%
0.00743 9.12E-04 8.86E-04 9.1 E-04 3.5% -0.10%
Table 7.11: Quanto prices for maturity of 6 months. Spot price is 0.0083 dollars. All the
prices are in the Euro currency.Strike prices in dollars.
Strikes BS Quanto HJ Quanto GARCH Quanto Rel.difference(HJ) Rel. difference(HN)
0.00970 4.68E-05 3.51E-05 4.07E-05 25% 12.88%
0.00911 9.92E-05 1.05E-04 1.55E-04 -6.51% -56.40%
0.00832 3.40E-04 3.7E-04 4.62E-04 -8.46% -36.30%
0.00755 8.59E-04 8.67E-04 9.14E-04 -0.03% -6.4%
0.00698 1.3E-03 1.34E-03 1.32E-03 1.72% 3.3%
Table 7.12: Quanto prices for maturity of 1 year. Spot price is 0.0083 dollars. All the call
prices are in the Euro currency.Strike prices in dollars.
7.5 Implementing a copula to price the FX quanto option
In sections 5.1.2 we discussed the methodology by which we would choose our copula from the
Archimedean family. We follow it to obtain the Frank Copula to model the dependence. The
58
Strikes BS Quanto HJ Quanto GARCH Quanto Rel. difference(HJ) Rel.difference(GARCH)
0.01047 7.43E-05 4.47E-05 6.85E-05 40% 7.8%
0.00950 1.57E-04 1.54E-04 2.26E-04 1.9% -44.20%
0.00826 5.39E-04 5.57E-04 6.40E-04 -3.3% -18.84%
0.00702 1.4E-03 1.38E-03 1.29E-03 1.85% 8.28%
0.00570 2.65E-03 2.67E-03 2.12E-03 -0.57% 20%
Table 7.13: Quanto prices for maturity of 2 year. Spot price is 0.0083 dollars. All the prices
Copulas will be used to model the dependence between the EUR/USD and EUR/JPY rates.
7.5.1 Parameter estimation for the T Copula
We used the Mashal and Zeevi (2002) approach discussed in Chapter 5 to find the optimal
degrees of freedom 𝜈, the correlation 𝜌𝑇 and the log likelihood value L for the T Copula. We
get the following results as in Table 7.14. We get the plot for the log likelihood function as in
Parameter Value
𝜈 14
𝜌𝑇 0.6
L 246.52
Table 7.14: Parameters for the T copula
Figure7.9.
59
Cannonical Maximum Likelihood Estimation (Mashal and Zeevi)
248
246
Value of Log−Likelihood Function

244
242
240
238
236
234
232
10 12 14 16 18 20 22 24 26 28 30
Degrees of Freedom
Figure 7.9: Canonical Log likelihood function (Mashal and Zeevi)
7.5.2 Parameter estimation for the Frank Copula
For the Frank Copula we get the Kendall Tau Rank Correlation (Γ) and 𝛼 as in Table 7.15
Parameter Value
Γ 0.00085
𝛼 0.0075
Table 7.15: Parameters for the Frank copula
7.5.3 Calibration of marginals
We take the marginals as the Heston with jump processes (please refer to section 5.0.3).
We now view the FX quanto as derivative where the underlying asset is the ratio of two exchange
rates(please refer to section 5.0.1). Hence we have to first calibrate to EUR/USD and EUR/JPY
dynamics to the market implied volatility quotes. We use the same calibration proceedure as in
60
section 7.1.
We obtain the following parameters after our calibration as shown in table 7.16.
Parameter EUR/USD EUR/JPY
𝜎0 0.1316 0.1667
𝜅 2.1963 2.1873
𝜂 0.0374 0.0435
𝜆 0.3931 0.2720
𝜌 -0.566 -0.4848
𝜃 0.14418 0.1203
𝜇 0.01678 0.01
𝜎𝐽 0.00136 0.0167
Table 7.16: Parameters for EUR/USD and EUR/JPY after calibration
We obtain the following fits to the market smile for the EUR/USD exchange rates as shown in
Figures 7.10-7.13. The fits to the EUR/JPY rates are shown in Figures 7.14-7.17. The RMSE
for both the calibrations to the implied volatilities are given in Table 7.17
Foreign Exchange RMSE
EUR/USD 0.037
EUR/JPY 0.083
Table 7.17: Root mean squared errors for the implied volatility fits on EUR/USD and
EUR/JPY FX rates
61
Volatilities on EUR/USD FX Options for maturity of 1 month
Market Volatility
Heston with jumps Volatiltity
0.135
0.13
Volatility
0.125
0.12
0.115
0.11
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Delta
Figure 7.10: Market and model volatility (in %) for EUR/USD call options with maturity 1
months
Volatilities on EUR/USD FX Options for maturity of 6 months
Market Volatility
0.135 Heston with jumps Volatiltity
0.13
0.125
Volatility
0.12
0.115
0.11
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Delta
Figure 7.11: Market and model volatility(in %) for EUR/USD call options with maturity 6
months
7.5.4 Numerical Results for pricing using copula
We have obtained the parameters required to price using both the Frank and the T Copula.
We also calibrated the Heston model with jumps for EUR/USD and EUR/JPY implied volatil-
ities.We give a picture of the innovations from the copula families which will be used in the
62
Volatilities on EUR/USD FX Options for maturity of 1 year
Market Volatility
0.13
0.125
Volatility
0.12
0.115
0.11
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Delta
months
Volatilities on EUR/USD FX Options for maturity of 2 years
Market Volatility
0.13
0.125
Volatility
0.12
0.115
0.11
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Delta
years
pricing of the quanto option in Figures 7.18 and 7.19.
Finally we compare the relative differences between all three methods from the Black Scholes
Model- The Heston model with jumps(HJ), The GARCH model(HN) and the Heston with jumps
model equipped with a copula (HJ + Copula) in Tables 7.18 to 7.22.
63
Volatilities on EUR/JPY FX Options for maturity of 1 month
Market Volatility
0.17
0.16
Volatility
0.15
0.14
0.13
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

Delta
Figure 7.14: Market and model volatility(in %) for EUR/JPY call options with maturity 1
months
Volatilities on EUR/JPY FX Options for maturity of 3 months
Market Volatility
0.17
0.16
Volatility
0.15
0.14
0.13
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

Delta
months
7.6 Monte Carlo Errors
In the dissertation we priced 25 quanto options. There were five maturities with five strikes or
deltas for each maturity. We used Monte Carlo simulations to price each of these options with
the GARCH model, Heston with jumps with a T copula and then a Frank Copula. We found
64
Volatilities on EUR/JPY FX Options for maturity of 6 months
Market Volatility
0.17
0.16
Volatility
0.15
0.14
0.13
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

Delta
months
Volatilities on EUR/JPY FX Options for maturity of 2 years
Market Volatility
0.17
0.16
Volatility
0.15
0.14
0.13
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

Delta
years
the standard errors for the Monte Carlo simulation of each of the 25 options; using all three
methods. We then took the average of the Monte Carlo errors for each of the methods.Hence
we have three values of errors for the three methods. The results are in Table 7.22.
65
Random sample from Frank Copula with pricing parameters Random sample from T Copula with the pricing parameters
1 1
0.8 0.8
0.6 0.6
v
v
0.4 0.4
0.2 0.2
0 0
0 0.2 0.4 0.6 0.8 1 0 0.2 0.4 0.6 0.8 1
u u
Figure 7.18: Frank Copula with 𝛼 = 0.0075 Figure 7.19: T Copula with 𝜈 = 14 and 𝜌 = 0.6
Delta RD(HJ) RD(GARCH) RD(HJ+Frank copula) RD(HJ+T copula)
0.1 -48% 12% -20% -53%
0.2 -42% -41% -12% -46%
0.5 -16% -29% -9% -22%
0.8 -2% -8% -1% -7%
0.9 2% -2% 1% 3%
Table 7.18: Relative Difference (RD)with Black Scholes for the models for maturity of 1 month.
Values have been rounded off.
66
Delta RD(HJ) RD(GARCH) RD(HJ+Frank Copula) RD(HJ+T Copula)
0.1 -1% 48% -1% -3%
0.2 -13% -19% -4% -17%
0.5 -8% -27% -2% -15%
0.8 1% -8% 1% 3%
0.9 4% -7% 3% 6%
Table 7.19: Relative Difference(RD)with Black Scholes for the models for maturity of 3 months.
0.10 17% 40% 14% 14%
0.20 -5% -34% -2% -6%
0.50 -7% -32% -5% -9%
0.80 1% -9% 1% -10%
0.90 4% -1% 3% 6%
Table 7.20: Relative Difference(RD)with Black Scholes for the models for maturity of 6 months.
67
0.10 25% 13% 22% 27%
0.20 -6% -56% -6% -10%
0.50 -8% -36% -9% -15%
0.80 -0.03% -6% -0.5% -3%
0.90 2% 3% 1% 6%
Table 7.21: Relative Difference(RD)with Black Scholes for the models for maturity of 1 year.
Simulation Samples Standard Monte Carlo Error
GARCH 80000 0.05
HJ + T Copula 100000 6.7E-03
HJ + Frank Copula 100000 5.1E-03
Table 7.22: Average Standard Monte Carlo errors.Each error is an average of 25 simulations
for 25 different quanto options.
68
Chapter 8
Conclusion
In the dissertation we priced an FX quanto call option under stochastic volatility models. The
quanto FX option has a closed form solution under a Black type of model. We used the prices
obtained from the Black type of model for comparison. We implemented three stochastic volatil-
ity models- the Heston model with jumps(HJ), the discrete form GARCH Option Pricing model
and the HJ model equipped with copulas. We observe tables 7.16, 7.17 and 7.18. The first
observation is that for short maturities and under stochastic volatility; options which are deep
in the money are priced higher than the Black Scholes model. This is more true for the Heston
Model with jumps and its extensions with the copula. We could say that stochastic volatility
had the effect of raising quanto call prices of in the money and at the money options. For out of
the money options the stochastic volatility model price turns out to be less by a small percentage
as compared to the Black Scholes price.
A stochastic volatility model allows fatter tails than the Black Scholes model. The probability
of in the money options to move towards the at the money region is higher. At the money call
69
options are priced more than in them money calls. This could explain that under stochastic
volatility we could get higher prices of in the money options. We see that the effect of the
overpricing of in the money options is more pronounced for shorter maturities. We observe that
under the T Copula the difference with the Black Scholes prices is more. With the Frank Copula
this difference is lower.
We calibrated the plain vanilla FX options before going on to price the quanto option. An in
built MATLAB local optimizer routine was used.The shortcoming in the calibration routine was
that it requires an initial guess. During the calibration exercise it was observed that depending
upon our initial choice we get very different parameter values. If the initial guess is inaccurate
then the optimisation converges to a local minimum point rather than a global minima. A global
optimisation routine would have been a better choice. This was a shortcoming in our pricing
proceedure.
We observe that there is a high percentage difference between prices obtained from the GARCH
and the Heston with jumps model; at times to around 60 per cent when options are deep in the
money. Both of them have been calibrated to the same dataset. This leads us to ask which of
the two models would have been suitable for pricing. The Heston model with jumps in our case
had a lower RMSE when calibrating to plain vanilla quotes. Given the data set we have worked
on the Heston model with jumps is a better choice as it did a better job of fitting vanilla quotes.
70
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74

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Pricing FX Quanto Options under

A dissertation submitted to the

in partial fulﬁllment of the requirements for the degree of

who ensured that we had the adequate facilities to work eﬃciently.

from a background where I had no knowledge of Computational Finance; these individuals

List of Tables viii

1.2 Pricing the FX quanto option under diﬀerent frameworks . . . . . . . . . . . . . 7

2 Pricing FX Quanto Options in the Black Scholes Framework 14

2.1 The standard market practice in pricing FX Quanto Options . . . . . . . . . . . 14

2.1.1 Pricing using the Black Scholes Model . . . . . . . . . . . . . . . . . . . . 15

3 Pricing of FX Quanto under the Heston Model 17

3.1 Revisiting the Heston model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

3.2 Option Pricing under the Heston model . . . . . . . . . . . . . . . . . . . . . . . 18

3.2.1 The Heston Pricer using Fast Fourier Transform . . . . . . . . . . . . . . 19

3.2.2 The Heston Trap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

3.3 The Heston model with jumps . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

4 Pricing of FX Quanto under the GARCH Option Pricing Model 26

4.1 Duan’s GARCH Option Pricing Model . . . . . . . . . . . . . . . . . . . . . . . . 26

4.2 Analytical Approximation of the GARCH Option Pricing Model . . . . . . . . . 28

5 Modelling the Dependence Structure Using a Copula 31

5.1 Archimedean Copulas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

5.1.1 Archimedean Copulas and their Measures of Dependence . . . . . . . . . 33

5.2 The T Copula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

5.2.1 Calibration of the T Copula . . . . . . . . . . . . . . . . . . . . . . . . . . 38

5.3 Pricing using the copula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

6.1 Discount Factors, Implied Volatility quotes . . . . . . . . . . . . . . . . . . . . . 41

6.2 Recovering Strikes and Prices of FX vanilla options . . . . . . . . . . . . . . . . . 42

7 Implementation of Pricing Methods 45

7.1 Implementation of the Heston Stochastic Volatility Model with Jumps . . . . . . 45

7.1.1 Calibration of the Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

7.1.2 Finding Implied Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

7.2 Implementation of the GARCH Option Pricing Model . . . . . . . . . . . . . . . 50

7.2.1 Calibration Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

7.3 Choosing a model to price the Quanto option . . . . . . . . . . . . . . . . . . . . 56

7.4 Results of pricing the quanto option . . . . . . . . . . . . . . . . . . . . . . . . . 56

7.5.1 Parameter estimation for the T Copula . . . . . . . . . . . . . . . . . . . 59

7.5.2 Parameter estimation for the Frank Copula . . . . . . . . . . . . . . . . . 60

7.5.3 Calibration of marginals . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

7.5.4 Numerical Results for pricing using copula . . . . . . . . . . . . . . . . . . 62

7.6 Monte Carlo Errors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

5.1 Frank Copula with 𝛼 = 1.5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

5.2 Clayton Copula with 𝛼 = 1.5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

5.3 Gumbel Copula with 𝛼 = 1.5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

7.1 Time series observations of USD/JPY spot exchange rate . . . . . . . . . . . . . 46

7.7 Market Implied Volatility Surface . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

7.8 Heston with Jumps Implied Volatility Surface . . . . . . . . . . . . . . . . . . . . 53

7.9 Canonical Log likelihood function (Mashal and Zeevi) . . . . . . . . . . . . . . . 60

7.18 Frank Copula with 𝛼 = 0.0075 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66

7.19 T Copula with 𝜈 = 14 and 𝜌 = 0.6 . . . . . . . . . . . . . . . . . . . . . . . . . . 66

5.1 Archimedean Copulas and their Generators . . . . . . . . . . . . . . . . . . . . . 33

5.2 Archimedean Copulas and Measures of Dependence . . . . . . . . . . . . . . . . . 34

6.2 EUR/USD implied volatility quotes of call options corresponding to standard

6.3 EUR/JPY implied volatility quotes of call options corresponding to standard

6.4 USD/JPY implied volatility quotes of call options corresponding to standard

7.1 Parameters of Heston with jumps calibration on USD/JPY rates . . . . . . . . . 48

7.2 Parameters of GARCH calibration on USD/JPY rates . . . . . . . . . . . . . . . 53

7.3 Implied volatilities for maturity of 1 month . . . . . . . . . . . . . . . . . . . . . 54

7.4 Implied volatilities for maturity of 3 months . . . . . . . . . . . . . . . . . . . . . 54

7.5 Implied volatilities for maturity of 6 months . . . . . . . . . . . . . . . . . . . . . 55

7.6 Implied volatilities for maturity of 1 year . . . . . . . . . . . . . . . . . . . . . . 55

7.7 Implied volatilities for maturity of 2 years . . . . . . . . . . . . . . . . . . . . . . 55

7.14 Parameters for the T copula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

7.15 Parameters for the Frank copula . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

7.16 Parameters for EUR/USD and EUR/JPY after calibration . . . . . . . . . . . . 61