PRICING FOREIGN EQUITY

OPTIONS UNDER LÉVY

PROCESSES
SHIAN-CHANG HUANG
MAO-WEI HUNG*

This article investigates the valuation of a foreign equity option whose

value depends on the exchange rate and foreign equity prices. Assuming
that these underlying price processes are correlated and driven by a multi-
dimensional Lévy process, a method suitable for solving the complex valu-
ation problem is developed. First, to reduce the number of dimensions of
the problem, the probability measure is changed to embed some dimen-
sions of the Lévy process into the pricing measure. Second, to simplify the
integral complexity of the discounted terminal payoff, the valuation prob-
lem is transformed to Fourier space. The main contribution of this study is
that by combining these two methods, the multivariate valuation problem
is significantly simplified, and very accurate results are obtained relatively
quickly. This powerful method can also be applied to other multivariate
pricing problems involving Lévy processes. © 2005 Wiley Periodicals, Inc.
Jrl Fut Mark 25:917–944, 2005

*Correspondence author, College of Management, National Taiwan University, No. 1, Section 4,

Roosevelt Road, Taipei, Taiwan; e-mail: hung@mba.ntu.edu.tw
Received September 2004; Accepted January 2005

■ Shian-Chang Huang is a Ph.D. candidate in the College of Management, National

Taiwan University in Taipei, Taiwan.
■ Mao-Wei Hung is a Professor in the College of Management, National Taiwan
University in Taipei, Taiwan.

The Journal of Futures Markets, Vol. 25, No. 10, 917–944 (2005) © 2005 Wiley Periodicals, Inc.
Published online in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/fut.20171
918 Huang and Hung

INTRODUCTION
With the expansion of international financial links and the continued lib-
eralization of cross-border cash flows, investors are increasingly exposed
to the foreign exchange risk and equity price fluctuations both at home
and abroad. Foreign equity options traded on international markets pro-
vide an efficient means of managing such multidimensional risks.
Derivatives of this type have provided investors with a vehicle for hedg-
ing against these risks, and consequently have become more and more
popular. Until recently, pricing such options was still quite difficult;
hence, the underlying price dynamics are generally restricted to simple
Brownian motions.
The objective in this article is to go beyond the traditional Black-
Scholes framework, and simultaneously provide an efficient and accurate
method of pricing these options. Compared with the existing literature,
all underlying price dynamics are generalized to Lévy processes, which
helps to capture actual price movements. Consequently, the problem
becomes pricing multivariate options under a correlated multidimen-
sional Lévy process. To efficiently solve this problem, suitable methods
are established for reducing the integration complexity and accelerating
the computation.
Previous studies dealing with cross-currency options (see Dravid,
Richardson, & Sun, 1993; Ho, Stapleton, & Subrahmanyam, 1995;
Reiner, 1992; Toft & Reiner, 1997) usually model the dynamics of
underlying assets with Brownian motions. Duan and Wei (1999) priced
quantos under GARCH using simulations. Kwok and Wong (1999) went
a step further and priced exotic foreign equity options in a Black-Scholes
framework. However, as demonstrated in numerous empirical articles,
both normality and continuity assumptions of the Black-Scholes model
are contradicted by extensive empirical data. Specifically, stock return
distributions are more leptokurtic than the Brownian motion.
Furthermore, option prices generally exhibit the famous volatility smile.
Simultaneously, jumps are clearly identifiable from equity data (see
Eraker, 2001; Eraker, Johannes, & Polson, 2003), and these jumps gen-
erally contribute to the stochastic volatility.
In the exchange rate modeling, Jorion (1988) points out that foreign
exchange markets are characterized by active management policies
(monetary or fiscal polices) that are absent from other securities
markets. Accordingly, stochastic processes that incorporate jumps might
reflect the rate of changes of foreign currency prices better than the pure
continuous diffusion process. Empirical results (see Jiang, 1998;
 Pricing Foreign Equity Options 919

Johnson & Schneeweis, 1994) indicate that jumps are important compo-
nents of the currency exchange rate dynamics, even when conditional
heteroscedasticity and mean reversion are considered.
In this study, the exchange rate and foreign asset prices are modeled
as correlated multidimensional Lévy process. To price these multivariate
options, the traditional measure change technique1 is first extended to
this new setting. Nevertheless, traditional results for option pricing
under jump-diffusion processes are very complicated, especially when
option formulas are expressed in the stock price space. However, more
recently studies have recognized that pricing problems involving Lévy
processes are much simpler in Fourier space (see Bakshi & Madan,
2000; Carr, Geman, Madan, & Yor, 2002; Carr & Madan, 1999), because
typical Lévy processes have very simple Lévy-Khinchine representa-
tion. Hence, the valuation problem is next transformed to the Fourier
space, and the option value is calculated with the Fourier inverse
transformation.
The main contribution of this study lies in combining both of the
above methods. The dimensionality of the problem is first reduced, and
then these options are priced with the use of the well-known Fourier
inverse transformation, which has many fast algorithms to accelerate the
computation. Thus, the proposed method outperforms traditional tech-
niques in numerical simulations. The method can yield highly accurate
solutions relatively quickly, and is also suitable for other multidimen-
sional pricing problems involving Lévy processes.
The article is organized as follows: In the next section basic stochas-
tic models of the exchange rate and foreign assets are presented. Then
the valuation method, which includes the measure change and the gen-
eralized Fourier inverse transformation, is introduced. Numerical analysis
is performed to discuss various factor effects on the price of a foreign
equity option. The last section concludes the article.

CROSS-CURRENCY FOREIGN
EQUITY OPTIONS
Over 15 years, foreign currency markets have been characterized by
large price fluctuations. The high-volatility and high-frequency jumps
of exchange rate movements have exposed international investors to

1
This method is strongly related to the selection of the numeraire, which was used in Shepp and
Shiryaev (1995), Kramkov and Mordecki (1995), Gerber and Shiu (1996), and Kallsen and Shiryaev
(2002).
920 Huang and Hung

considerable currency risks. Consequently, currency options markets

have appeared to provide new means of dealing with this growing risk.
Currency options are traded on several security exchanges throughout
the world. A significant over-the-counter market has also developed,
offering various specialized currency options.

Foreign Equity Options Struck in Foreign

or Domestic Currency
Foreign equity options, as their name suggests, are pegged to foreign
equities, with the strike price being in either foreign or domestic currency,
but with the payoff being transformed into domestic currency at the
exchange rate existing on expiration. The payoff of a foreign equity
option struck in a foreign currency is given by

FEOF
FT (ST  Kf )  (1)

where FT is the exchange rate at time T in the domestic/foreign currency,

ST is the stock price in the foreign currency on expiration, and Kf is the
strike price in the foreign currency.
When an investor wishes to make sure that the future payoff from
the foreign market is meaningful when converted into his or her own
currency, then a foreign equity option struck in the domestic currency is
appropriate. Such an option has the following payoff

FEOD
(FT ST  Kd )  (2)

where Kd is the strike price in the domestic currency.

Quanto and Swap Options

The most popular type of currency-translated options are Quanto
options (quantity adjusted options or guaranteed exchange rate options).
These are foreign equity options with a fixed exchange rate. Thus
Quanto options help investors protect themselves against exchange rate
fluctuations. The payoff of such options is given by:

Quanto
F(ST  Kf )  (3)

where F is the predetermined exchange rate in the domestic/foreign cur-

rency, ST is the stock price in the foreign currency on expiration, and Kf
is the strike price in the foreign currency. Swap options differ from
 Pricing Foreign Equity Options 921

Quanto options in providing investors with the right to exchange one for-
eign asset for another. That is, swap options offer further investment
protection for investors. The payoff of a swap option is given by

Swap
FT (S1T  S2T )  (4)

Equity-Linked Foreign Exchange Options

When investors wish to place a floor on the exchange rate component of
their investment in foreign equities, they can combine a currency call
and an equity forward to create an equity-lined exchange call with the
following payoff:

ELFX
ST (1  KFT )  (5)

which is equivalent to

ELFX
ST (FT  K)  (6)

where FT is the exchange rate at time T in the foreign/domestic currency,

and K is the strike price in the domestic currency.

VALUATION METHODS UNDER

LÉVY PROCESSES
Traditionally, securities prices are modeled as geometric Brownian
motions. A relatively simple yet powerful generalization is the class of all
processes with independent increments and stationary distributions.
This set of processes are Lévy processes (see the monographs by Bertoin,
1996 and Sato, 1999).

Types of Lévy Processes

Generally, Lévy processes are a combination of a linear drift, a Brownian
motion, and a jump process. When jumps occur, Lévy process Xt jumps
by ¢Xt
x 苸 ⺢506 (the notation means that zero is excluded as a possi-
ble jump amplitude). Now consider any closed interval A 苸 ⺢ that does
not contain 506 . Then, the cumulative number of jumps in the time
interval [0, t] with a size that belongs to A, denoted by NAt , is a random
variable that is also a random measure. This integer-valued random
measure is usually written as NAt
n([0, t], A) . With a fixed A, then NAt
922 Huang and Hung

has a Poisson distribution with a mean value t 兰A p(x) dx, where p(x) is
the Lévy measure, which measures the relative occurrence of different
jump amplitudes (see Sato, 1999, Theorem 1.4).
With the use of the integration theory in a discontinuous stochastic
process, any Lévy process Xt can be decomposed into the general repre-
sentation form:
t
Xt
mt  sBt  冮冮
0 ⺢506
(xn(ds, dx)  h(x)p(x) dx ds) (7)

where Bt is a Brownian motion, and m, s are constants. Moreover, h(x)

is a truncation function, and the Brownian motion and jump process are
independent.
Table I shows that, depending on differences in jump component,
Lévy processes can be classified into Type I, finite-activity models;
and Type II, infinite-activity models. Type I models (the Poisson case)
are characterized by the feature: 兰R p(x) dx   . One can write
p(x)
lf(x) , where l
兰R p(x) dx is the Poisson intensity (the mean
jump arrival rate), and f(x) dx
dF(x) , where F(x) is a cumulative prob-
ability distribution. This case can also be called the jump diffusion.

TABLE I
Two Types of Lévy Processes

Finite-activity models
Characteristic function °(z
iw)

Lognormal
exp{iwmT  12 w 2s2T  lT(eiwmJ  (1兾2)w sJ  1)}
2 2
Jump diffusion
Double exponential 1  h2
Jump diffusion exp e iwmT  12 w 2s2T  lT a eiwk  1b f
1  w 2h2

Infinite-activity models
Characteristic function °(z
iw)

Variance gamma exp(iwmT )(1  iwnu  12 s2nw 2 ) T兾n

Normal inverse Gaussian exp{iwmT  dT(2a2  b2  2a2  (b  iw) 2 )}

a2  b2 Kld2a2  (b  iw) 2
lT
T
b a b
2

Generalized hyperbolic exp(iwmT )a

a  (b  iw)
2 2
Kld2a2  b2
Finite-moment stable exp(iwmT  (iws) aT sec pa
2 )

CGMY exp(C (Y )((M  iw) Y  MY  (G  iw) Y  GY ) )

 Pricing Foreign Equity Options 923

An example of this type of process is Merton’s (1976) jump-diffusion

model, where x is has a normal distribution:

(x  mJ ) 2

b
1
p(x)
l f(x)
l expa (8)
2ps2J 2s2J

Another example is where x has a double exponential distribution (Kou,

2000):

|x  k|
b
1
p(x)
l f(x)
l expa (9)
2h h

Alternatively, no overall Poisson intensity can be defined for the

Type II cases, where 兰R p(x) dx
 . A simple example is the Lévy
a-stable process:

c;
p(x)
, 0a2 (10)
|x|1a

where c; are two constants for x 0 and x  0. Carr and Wu (2003)

provide a concrete example of this model. Two alternative particular
classes of pure jump Lévy processes are the generalized hyperbolic
motion and the CGMY process. Generalized hyperbolic motions have
been introduced to the finance literature by Eberlein and Keller (1995)
and Barndorff-Nielsen (1998); moreover, CGMY processes were intro-
duced by Geman, Madan, and Yor (2001) and Carr et al. (2002). In the
CGMY model, p(x) is given by

p(x)
C|x|1Y (exp(Gx)1x  0  exp(Mx)1x 0 ) (11)

Notice that in Type II models, Lévy measure p(x) cannot be integrated

at the origin, because there are too many small jumps. However, the
Lévy-Khinchine representation (see below) guarantees that p(x) is
always integrable near the origin.

Market Models
Option values are well known as the integral of a discounted transition
density times a payoff function. The integration is usually done in ST
space, where ST is the terminal security price. However, for Lévy
processes the ST -space transition densities are often very complicated,
involving many special functions and infinite summations. However, it is
much easier to calculate the option value as an integral in Fourier space.
924 Huang and Hung

The option formula is simplified, because in the Fourier space typical

Lévy processes have very simple Lévy-Khinchine representation, and
their characteristic exponents are fully determined by a characteristic
triple.
The multidimensional Lévy process is formally introduced below.
Let X be a d-dimensional Lévy process defined on a stochastic space
( , F, Q) . Define EezXt
exp(tc(z) ) , where the function c(z) is known
as the characteristic exponent of process X. Then the Lévy-Khinchine
formula states that c(z) is given by

az, a zb  冮 (e
1
c(z)
(m, z)  (z,y)
 1  (z, y)1 0 y0 1 ) q (dy) (12)
2

where m is a vector in ⺢d, and  is a positive Lévy measure defined on

⺢d \506 such that 兰 ( 0 y 0 2 ¿ 1)(dy) is finite, and ©
((sij )) is a sym-
metric nonnegative definite variance matrix that can always be expressed
as ©
AA (where the prime denotes transposition) for some matrix A.
The triplet (m, ©,  ) completely determines the law of process X. In the
case in which l
兰 (dy) is finite is of particular interest. Namely, X is
a jump-diffusion or a finite-activity Lévy process. Introducing F by
(dy)
lF(dy) , the Lévy-Khinchine formula changes to (changing the
value of m if necessary)

az, a zb  冮 (e
1
c(z)
(m, z)  (z,y)
 1) q (dy) (13)
2

and the multidimensional process Xt can be represented by

Nt
Xt
mt  ABt  a Yk (14)
k
1

where B is a standard d-dimensional Brownian motion, N
5Nt 6 t

0 is
a Poisson process with parameter l, and 5Yk 6 k
1 is a sequence of inde-
pendent d-dimensional random vectors with identical distribution
F(dy) .

The Pricing Approach

Consider a market model with one exchange rate and two foreign assets
(F1, S2, S3 ) given by
1 2 3
F1t
F10 eV t, S2t
S20 eV t, S3t
S30 eV t (15)
 Pricing Foreign Equity Options 925

where (V1, V2, V3 ) is a three dimensional Lévy process. In the market, a

derivative contract with payoff given by

£ t
F1t g(S2t , S3t ) (16)

is considered. For mathematical simplicity, assuming that there already

is a risk-neutral martingale measure; namely, Q is an equivalent mar-
tingale measure (EMM). The derivative contracts introduced in the
previous section are to be priced. In a European call, the problem is
reduced to

CT
C(F10, S20, S30, T)
erdTEQ[F10eVTg(S20eVT , S30eVT )]

1 2 3
(17)

where rd is the domestic interest rate.

The main method to solve the problem is to make a change of the
pricing measure through Girsanov’s theorem first, in which one dimen-
sion of the stochastic processes, such as the exchange rate, is incorpo-
rated into the pricing measure. More precisely, observe that (if g is a
linear payoff)

F10eVt g(S20eVt , S30eVt )
F10eVt Vt g(S20eVt Vt , S30 )

1 2 3 1 3 2 3
(18)

Let b
log EeV1 V1 , and then the process

1 3

eVt Vt
1 3

V1t V3t bt

qt
e
(19)
EeVt Vt
1 3

~
is a density process that allows a new martingale measure Q to be intro-
duced by the formula
~
dQt

qt (20)
dQt
~ ~ ~
Denote Vt by Vt
V 2t  V3t and Yt
S20eVt . Under the change of
measure,
~ ~
CT
erdTEQ[ebtG(YT, S30 )]
erdTEQ[ebtG(YT )] (22)

FEOF Options
Let (V1t , V2t ) be a bidimensional Lévy process. The following is a demon-
stration of how to obtain a formula for the value of an FEOF option. Let
926 Huang and Hung

F1T be the terminal exchange rate and S2T be the price of a risky foreign
asset, and thus a contract with payoff F1T (S2T  K)  can be priced with
the use of the above method:

FEOF
erdTEQ[F1T (S2T  K) ] (23)

Let C
5v 苸 : S2T (v) K6 , and proceed with the proposed method.

~
First, by changing the original measure Q to Q, observe that b

1
log EeV1, and then:

&
1
eVT
dQ
Q V1 dQ (24)
E e T

With all this:

冮 ~
FEOF
erdT F10 (EQeVT )(S2T  K) dQ
C
1

冮 ~

erdTebTF10 (S2T  K) dQ
C
~

e(rdb)TF10 EQ (S2T  K; C)
~

e(rdb)TF10 EQ (S2T  K) (25)

Swap Options
Let (V1t , V2t , V3t ) be a tridimensional Lévy process. To obtain a formula
for the value of a foreign swap option, first, let F1T be the terminal
exchange rate and S2T, S3T be prices of two risky foreign assets. A contract
with payoff F1T (S2T  S3T )  can be priced using the method described
previously.

Swap
erdTEQ[F1T (S2T  S3T ) ] (26)

Let C
5v苸 : S2T (v) S3T (v)6 , and change the original measure Q to
~
Q; observe that

eV T VT
1 3
~
dQ
dQ (27)
EQ (eVT VT )
1 3
 Pricing Foreign Equity Options 927

and b
log EeV 1 V 1. With all this:

1 3

S2T
Swap
e rdT
冮
C
F10 (EQeVT VT )a
1 3

e VT3
 S30 b dQ
~

S2T

erdTebTF10 a 冮 C e VT3
 S30 b dQ
~

冮C
2 3 ~

e  (rdb)TF10 (S20eVT VT  S30 ) dQ

~

e  (rdb)TF10EQ(YT  S30; C)
&

e  (rd b)TF10EQ (YT  S30 ) (28)
&
苲
where YT
S20eVT and V
V2  V3.

Distributions Under Measure Changes

~
To determine the law of process X under the new measure Q, let V be a
multidimensional Lévy process (V is on ⺢2 for the FEOF option, but
on ⺢3 for Swap options), and V has a characteristic exponent given
in Equation (12). Let f and u be two vectors; moreover, assume that
Ee(f,V1) is finite, and denote b
log Ee(f,V1)
c(f) [referring to
Equations (18)–(22), f is (1, 0) for the FEOF option, and (1, 0, 1) for
~
the Swap option]. Under these conditions, the probability measure Q by
its restrictions to Ft is introduced as
~
dQt

exp[(f, Vt )  bt] (29)
dQt

A particular case is that V follows a diffusion with jumps; then the jump
part has its characteristic exponent (under Q) given by

c(z
iw)
冮e
3
⺢
(iw, y)
F(dy) (30)

and two special distributions of the jump size are (a) Gaussian jumps

c(z
iw)
ei(w,mJ)  (1兾2)(w,¢w) (31)

928 Huang and Hung

and (b) double-exponential jumps

1  h2 iwk
c(z
iw)
e (32)
1  w2h2

The law of the unidimensional Lévy process 5 (u, Vt )6 t

0 [u is (0,1) in the
~
FEOF case, and (0, 1, 1) for Swap options] under Q is given by the
triplet (detailed proof is given in Appendix A):

~
(m, u)  1 c au, fb  af, ub d

m
2 a a

~
a
au, a fb (33)

~
q
冮⺢3
1(u,y)僆Ae(f,y) q (dy)

Furthermore, assuming that (dy)
lF(dy) , where F is the common

distribution of the random variables 5Yk 6 , the intensity of the Poisson
~
process under Q is found to be given by

~
l
冮⺢ 3
e(f,y) q (dy)
l 冮
⺢ 3
e(f,y)F (dy) (34)

~
Then, the characteristic exponent of the same random variables under Q
is given by (detailed proof is given in Appendix B)

~ c(zu  f)
c(z)
(35)
c(f)

For example,

~ eiwuk (1  f2h2 )
c(z
iw)
(36)
1  (wu  f) 2h2

and

~ l
l
(37)
4  4h2

in double-exponential jumps. Moreover,

~
c(z
iw)
exp5iw((u, mJ )  12[(u, ¢f)  (f, ¢u)])  12 w2 (u, ¢u)6 (38)
 Pricing Foreign Equity Options 929

and
~
l
le(mJ, f)  (1兾2)(f, ¢f) (39)

in multidimensional normal jumps.

Fourier Transformations of Option Prices

Traditionally, the Fourier transformation of a standard European call
price may be expressed in terms of the log of the strike (k
ln K) as

g(u)
冮 
eiukeakC(k) dk (40)

where the call has a strike ek and the term eak is meant to ensure the con-
vergence of the integral. Call prices are then recovered by the inversion,

eak
C(k)

2p 冮
eiukg(u) du (41)

As discussed, characteristic functions °(z) are typically regular

functions in z-plane strips. It is next shown that the same holds true for
the transformation of a typical option payoff function. With x
ln ST,
let g(x) be the option payoff function, and denote its generalized Fourier
transformation as

ĝ(z)
F[g(x)]
冮
exp(izx)g(x) dx, z苸⺓ (42)

For example, consider the call option payoff, g(x)
(ex  K) , and by a
simple integration

exp[(iz  1)x] exp[izx] x


ĝ(z)
a K b` (43)
iz  1 iz x
ln K

The upper limit x
 in (43) does not exist unless Im z 1. With this
restriction, (43) is well defined and can be simplified as

K1iz
ĝ
 , Im z 1 (44)
z2  iz

Thus, by introducing the generalized Fourier transformation, standard

payoffs that are unbounded at x
 (the call), or at x
 (the put)
930 Huang and Hung

and have no regular Fourier transformation can be handled. All of the

typical payoff functions that one might encounter in practice can conse-
quently be handled.
Generalized Fourier transformations are inverted by integrating
along a straight line in the complex z plane, parallel to the real axis, with
z within the strip of regularity. For example, if n
Im z, then the payoff
functions are given by
in

冮
1
g(x)
eizxĝ(z) dz (45)
2p in

The option value can be calculated by

in

冮
1 rT
V(S0 )
e eizY ° T (z)ĝ(z) dz (46)
2p in

where Y
log S0  (r  q)T . For example, the value of a call option is

n 苸(1, g)
in1
KerT
冮
dz
C(S0, K, T)
eizk ° T (z) , 1 (47)
2p in1
z  iz
2

where g 1 [for the convergence of integral in (47)] and

k
log a b  (r  q)T
S0
(48)
K

General formula (46) can be viewed as a result of Parseval’s theory,

 

冮 冮
1
g(x)pT (x) dx
ĝ(u)°*(u)
T du (49)

2p 

The Parseval’s theory also provides a starting point formula with many
variations. By using residue theorems (complex analysis), one can
rearrange the Fourier inversion formula into the Black-Scholes form:

C(S, K, T)
SeqT q  KerT q (50)

1 2

where

eiuk ° T (u  i)
冮 Re c d du
1 1
q1
2  p iu
(51)
o
 Pricing Foreign Equity Options 931

and

eiuk ° T (u)
冮 Re c d du
1 1
q2
2  p iu
(52)
o

NUMERICAL RESULTS
In this section, numerical analysis is performed to obtain an insight into
the influences of various factors on FEOF and Swap option prices. In the
first part, from Figures 1–6, the effects of various parameters on the
FEOF option price are considered. Specifically, in Figures 1–3, the jump
amplitudes of these Lévy processes are assumed to be normally distrib-
uted. Meanwhile, in Figures 4–6, the jump amplitudes are assumed
to be exponentially distributed. In the second part, from Figures 7
through 12, the impacts of various parameters on the Swap option price
are considered. Similarly, the Lévy processes with normal jumps are
considered first in Figures 7–9, followed by considering the processes
with exponential jumps in Figures 10–12.

FEOF Option Prices

First, consider FEOF option prices under normal jumps; six factors influ-
ence the price of an FEOF, including diffusion parameters m, g ; jump
parameters l, mJ, sJ; and initial stock value S0. In Figures 1–6, typical
values of option pricing analyses are set for numerical simulations.
These values are q
0, rd
3%, K
2, F0
1, T
1, m
(0.1, 0.2),
mJ
(0, 0) , and

s21 s12
a
[s ij]
c d
s21 s22
s2J1 0
¢
[sJij]
c d
0 s2J2

That is, the diffusion parts are correlated, and the jump parts are
independent.

The Impact of Initial Asset Price

S0 on FEOF Prices
Figure 1 illustrates FEOF option prices under different initial stock price
S0 and volatility s2 with l
0.01. Figure 1 shows that FEOF option
932 Huang and Hung

vol=0.4
1.8 vol=0.6
vol=0.8
lower bound
1.6

1.4

1.2
option price

0.8

0.6

0.4

0.2

0
1 1.5 2 2.5 3 3.5 4
stock price S(0)

FIGURE 1
The effect of initial stock price S(0) on the FEOF option price under normal jumps.
In these models, we set K
2,T
1,rd
3%, l
0.01, m
(1%, 2%),
g
(0.52, 0.01; 0.01, s22 ) , and mJ
(0, 0), ¢
(0.12, 0; 0, 0.12 ).
We use vol to represent s2 in this figure.

price is an increasing function of S0. This phenomenon is consistent

with intuition, because the terminal payoff is likely to increase with S0.
Therefore, the option is valuable.

The Impact of Diffusion Volatility s2

on FEOF Prices
Figure 1 also reveals that the FEOF option price is an increasing func-
tion of s2. Large s2 increases the chance that at the terminal date the
stock will do either very well or very poorly; the option owner will benefit
from the price increase, but will have limited downside risk in the event
of a price decrease, since his or her maximum loss will be the price of the
option. Accordingly, the option becomes valuable if s2 increases.

The Impact of Jump Size Volatility sJ2

on FEOF Prices
Figure 2 displays FEOF option prices under different diffusion volatility
s2 and jump size volatility sJ2 with S0
1.8, l
0.3. Figure 2 shows
 Pricing Foreign Equity Options 933

0.4

0.35

0.3

0.25
option price

0.2

0.15

0.1

0.05

0
1
0.8 0.8
0.6 0.6
0.4 0.4
0.2 0.2
vol 0 0
vol of jump

FIGURE 2
The effects of diffusion volatility s2 and jump size volatility sJ2 on the FEOF option price
under normal jumps. In these models, we set K
2, S0
1.8, T
1, rd
3%, l
0.3,
m
(1%, 2% ), g
(0.52, 0.01; 0.01, s22 ) , and mJ
(0, 0), ¢
(0.42, 0; 0, s2J2 ) .
We use vol to represent s2, and use vol of jump to represent sJ2 in this figure.

that the FEOF option price is an increasing function of sJ2. The reason-
ing behind the phenomenon is the same as the diffusion volatility. The
influence of sJ on the option price is small under low l. However,
the impact increases for large l, and the influence of sJ2 may exceed
that of s2.

The Impact of Jump Frequency l

on FEOF Prices
Figure 3 shows FEOF option prices under different jump frequency l2
and diffusion volatility s with S0
1.9, sJ
0.4. FEOF option price is
an increasing function of l. The possibility of large upside benefits
increases with large jump frequency, but the nonlinearity of payoffs of
FEOF options limits the downside loss; consequently, FEOF options are
valuable under large l. To summarize, Lévy process parameters s, sJ, S0,
and l all positively impact the FEOF option price.
934 Huang and Hung

0.45

0.4

0.35

0.3
option price

0.25

0.2

0.15

0.1

0.05

0
0.8

0.6 1
0.8
0.4 0.6
0.2 0.4
0.2
lambda 0 0
vol

FIGURE 3
The effects of diffusion volatility s2 and jump frequency l on the FEOF option price
under normal jumps. In these models, we set K
2, S0
1.9, T
1, rd
3%,
m
(1%, 2%), g
(0.52, 0.01; 0.01, s22 ) , and mJ
(0, 0), ¢
(0.42, 0; 0, 0.42 ) .
We use vol to represent s2, and use lambda to represent l in this figure.

Figures 4–6 also consider the impacts of various parameter changes

on FEOF option prices. However, these figures assume that all jump
sizes of these Lévy processes are exponentially distributed, and k
0 is
set for a symmetric jump between Y axes. As illustrated in Figures 4–6,
the results resemble the corresponding case of Gaussian jumps. Under
exponential jumps, large h indicates large mean jump size, and thus
increases the value of an option. However, the influence of h on the
option price is quite nonlinear compared to that of s2. As h exceeds
some threshold, its influence on the option price becomes significantly
exceeds that of s2.

Swap Option Prices

Second, Swap option prices under normal and exponential jumps are
considered. Six factors affect the price of Swap options, namely, S0, m,
 Pricing Foreign Equity Options 935

vol=0.4
1.8 vol=0.6
vol=0.8
lower bound
1.6

1.4

1.2
option price

0.8

0.6

0.4

0.2

0
1 1.5 2 2.5 3 3.5 4
stock price S(0)

FIGURE 4
The effect of initial stock price S(0) on the FEOF option price under exponential jumps.
In these models, we set K
2, T
1, rd
3%, l
0.01, h
0.5, k
0, m
(1%, 2%),
g
(0.52, 0.01; 0.01, s22 ). We use vol to represent s2 in this figure.

0.4

0.35

0.3

0.25
option price

0.2

0.15

0.1

0.05

0
0.8

0.6 1
0.8
0.4 0.6
0.2 0.4
0.2
vol 0 0
eta

FIGURE 5
The effects of diffusion volatility s2 and mean jump size h on the FEOF option price
under exponential jumps. In these models, we set K
2, S0
1.8, T
1, rd
3%,
l
0.375, m
(1%, 2%), g
(0.32, 0.01; 0.01, s22 ) . We use vol
to represent s2, and use eta to represent h in this figure.
936 Huang and Hung

0.5

0.4

0.3
option price

0.2

0.1

0
0.8

0.6 1
0.8
0.4 0.6
0.2 0.4
0.2
lambda 0 0
vol

FIGURE 6
The effects of diffusion volatility s2 and jump frequency l on the FEOF option price
under exponential jumps. In these models, we set K
2, S0
1.9, T
1, rd
3%,
h
0.5, k
0, m
(1%, 2%), g
(0.32, 0.01; 0.01, s22 ) . We use vol to represent s2,
and use lambda to represent l in this figure.

g , l, mJ, sJ. In Figures 7–12, q
0, rd
3% , K
2, F0
1, T
1,

m
(0.1, 0.2, 0.2) , mJ
(0, 0, 0) , and

s21 s12 s13

a
[sij]
£ s21 s22 s23 §
s31 s32 s23
s2J1 0 0
¢
[sJij]
£ 0 s2J2 0 §
0 0 s2J3

The Impact of Variable S2(0)兾S3(0)

on Swap Prices
Figure 7 illustrates Swap option prices given different initial stock price S2
and diffusion volatility s2 with l
0.01, S3 (0)
2, s3
0.6. Figure 7
reveals that the Swap option price is an increasing function of S2 (0)兾S3 (0).
 Pricing Foreign Equity Options 937

vol=0.4
1.8 vol=0.6
vol=0.8
lower bound
1.6

1.4

1.2
option price

0.8

0.6

0.4

0.2

0
0 0.5 1 1.5 2 2.5 3 3.5 4
stock price S2(0)

FIGURE 7
The effect of initial stock price S2 (0) on the Swap option price under normal jumps.
In these models, we set K
2, T
1, rd
3%, l
0.33, m
(1%, 2%, 2%),
g
(0.32, 0.01, 0.01; 0.01, s22, 0.01; 0.01, 0.01, 0.32 ) , and mJ
(0, 0, 0),
¢
(0.42, 0, 0; 0, 0.42, 0; 0, 0, 0.42 ) . We use vol to represent s2 in this figure.

In this situation, S2 (0)兾S3 (0) can be considered as an equivalent initial

stock price, while the equivalent strike price is 1. The same reasoning
employed in Figure 1 can then be applied here. Another important point is
that some crossover points exist between different price curves. In the present
case, the crossover point occurs at S2 (0)兾S3 (0) ⯝ 0.75. These crossover
points are caused by the value assigned to s3. The slope of the price curve
is flat when s2  s3 and steepens when s2 s3, and consequently
crossover points appear. Comparing Figures 1 and 7 reveals that the addi-
tional volatility introduced by asset S3 increases the value of the Swap
option. This finding is not surprising.

The Impacts of Asset Volatility s2, sJ2

on Swap Prices
In Figure 8, set l
0.75 to amplify the jump effects. Figure 8 dis-
plays Swap option prices under different s2 and sJ2 with S0
1.8,
938 Huang and Hung

0.45

0.4

0.35
option price

0.3

0.25

0.2
1

0.8 0.8

0.6 0.6
0.4
0.4
0.2
vol 0.2 0
vol of jump

FIGURE 8
The effects of diffusion volatility s2 and jump size volatility sJ2 on the Swap option
price under normal jumps. In these models, we set K
2, S0
1.8, T
1, rd
3%,
l
0.75, m
(1%, 2%, 2% ), g
(0.32, 0.01, 0.01; 0.01, s22, 0.01; 0.01, 0.01, 0.32 ) ,
and mJ
(0, 0, 0), ¢
(0.42, 0, 0; 0, s2J2, 0; 0, 0, 0.42 ) . We use vol to represent s2,
and use vol of jump to represent sJ2 in this figure.

s1
s3
0.3, sJ1
sJ3
0.4. Deliberately varying only s2 and sJ2

enables the volatility effect of just one risky asset, S2, to be seen. Fig-
ure 8 reveals that the Swap option price is an increasing function of both
s2 and sJ2. Both s2 and sJ2 represent some kinds of volatilities, which
increase the potential upside benefit. Hence, large s2 and sJ2 increase
the value of the option.

The Impact of Jump Frequency l on Swap Prices

Figure 9 shows Swap option prices under various jump frequency l
and diffusion volatility s2 with S0
1.9, sJ1
sJ2
sJ3
0.4, s1

s3
0.3. Numerical results reveal that the Swap option price increases
with increasing l. This phenomenon is not surprising, because the
 Pricing Foreign Equity Options 939

0.5

0.45

0.4

0.35
option price

0.3

0.25

0.2

0.15

0.1
0.8

0.6 1
0.9
0.4 0.8
0.7
0.6
0.2 0.5
0.4
lambda 0 0.3
vol

FIGURE 9
The effects of diffusion volatility s2 and jump frequency l on the Swap option price
under normal jumps. In these models, we set K
2, S0
1.9, T
1, rd
3% ,
m
(1%, 2%, 2%), g
(0.32, 0.01, 0.01; 0.01, s22, 0.01; 0.01, 0.01, 0.32 ) ,
and mJ
(0, 0, 0), ¢
(0.42, 0, 0; 0, 0.42, 0; 0, 0, 0.42 ) . We use vol to
represent s2, and use lambda to represent l in this figure.

possibility of large upside benefits increases with large l. Comparing the

relative impacts of l and s2 on option prices reveals that the impact of
s2 is more nonlinear than that of l.
Figures 10–12 also consider the influences of various parameter
changes on Swap option prices. However, these figures assume that all of
the jump sizes of these Lévy processes are exponentially distributed, and
k
0 is set for a symmetric jump between Y axes. Figures 10–12 show
that the numerical results of option prices resemble the corresponding
case of Gaussian jumps. Figure 12 sets s
s2
s3 to reveal the effects
of simultaneous volatility changes. Figure 12 shows that the Swap option
price is an increasing function of s2, s3, but the impact becomes more
nonlinear in simultaneous volatility changes.
940 Huang and Hung

vol=0.4
1.8 vol=0.6
vol=0.8
lower bound
1.6

1.4

1.2
option price

0.8

0.6

0.4

0.2

0
0 0.5 1 1.5 2 2.5 3 3.5 4
stock price S2(0)

FIGURE 10
The effect of initial stock price S2 (0) on the Swap option price under exponential
jumps. In these models, we set K
2, S0
2, T
1, rd
3%, l
0.01, k
0,
m
(1%, 2%, 2%), g
(0.32, 0.01, 0.01; 0.01, s22, 0.01; 0.01, 0.01, 0.32 ) .
We use vol to represent s2 in this figure.

0.22

0.2

0.18

0.16
option price

0.14

0.12

0.1

0.08

0.06
0.8

0.7 0.8

0.6 0.6
0.4
0.5
0.2
vol 0.4 0
eta

FIGURE 11
The effects of diffusion volatility s2 and mean jump size h on the Swap option price
under exponential jumps. In these models, we set K
2, S0
2, T
1, rd
3%,
l
0.5, k
0, m
(1%, 2%, 2%), g
(0.32, 0.01, 0.01; 0.01,
s22, 0.01; 0.01, 0.01, 0.32 ) . We use vol to represent s2, and
use eta to represent h in this figure.
 Pricing Foreign Equity Options 941

1.8

1.6

1.4
option price 1.2

0.8

0.6

0.4

0.2

0
1

0.8 1.5

0.6
1
0.4

vol 0.2 0.5

S2(0)/S3(0)

FIGURE 12
The effects of variable S2 (0)兾S3 (0) and diffusion volatility s2, s3 on the Swap option
price under exponential jumps. In these models, we set K
2, T
1, rd
3% ,
l
0.375, h
0.6, k
0, m
(1%, 2%, 2%), g
(0.32, 0.01, 0.01; 0.01,
s22, 0.01; 0.01, 0.01, s23 ) . In this figure, we set s2
s3 and use vol to
represent s2 and s3.

CONCLUSION
This study mainly considered the valuation problems of foreign equity
options and foreign swap options. Specifically, the exchange rate and for-
eign asset prices were modeled as a correlated multidimensional Lévy
process. To reduce the number of dimensions of the problem, some
dimensions of the Lévy process were first embedded into the pricing
measure. Second, the valuation problem was transformed to Fourier
space, and calculated the option value with the use of Fourier inversions.
Owing to the Lévy-Khinchine formula, the integrand in the Fourier
inversion is typically a compact expression with only elementary func-
tions; thus, the computation is simplified.
Adopting these two methods can significantly simplify the multivari-
ate valuation problem, and can obtain highly accurate results relatively
quickly. Regarding numerical results, Lévy process parameters s2, sJ2,
h, S2 (0) , and l were all found to positively influence the FEOF option
price. The jump frequency l determines whether the impact of sJ2 is
larger or smaller than that of diffusion volatility s2. In Swap options, the
relative magnitudes of s2 and s3 determine the total impact of diffusion
volatilities. In computation loading, the proposed method outperforms
traditional techniques.
942 Huang and Hung

To summarize, the powerful method established in this study can

also applied to other multivariate pricing problems involving Lévy
processes, for example, basket options or portfolio options. A challeng-
ing future task is to incorporate the stochastic volatility and copula
functions into a multidimensional Lévy process to capture important
financial phenomena such as fat tails and volatility smiles.

APPENDIX A
~
First compute the expectation under Q as an expectation under Q,
~
Eez(u, Xt)
Ee(fzu, Xt)bt
exp5t[c(f  zu)  c(f)]6

Next, compute the characteristic exponent of (u, V)

c(f  zu )  c(f )

c a f  zu, a (f  zu )b  a f, a fb d
1

(m, f  zu )  (m, f ) 
2

 冮 (e
⺢ 3
(f  zu,y)
 1 ) q (dy)  冮 (e⺢3
(f,y)
 1 ) q (dy)

z e (m, u )  c a u, a fb  a f, a ub d  z2 (u, ©u )
1 1
2 2

 冮 (e
⺢3
(f  zu,y)
 e (f,y) ) q (dy)

~, z)  1 a z, ~ zb  ~

(m
2 a 冮 (e
⺢3
(zu,y)
 1 ) q (dy)

APPENDIX B
~ ~ ~ ~
As the distribution of the jumps under Q is given by (1兾l)(dy)
F(dy) ,

冮e
~ 1 ~
c(z)
~ zx
(dx)
l ⺢3

冮e
l

~ zuf,y
F (dy)
l ⺢ 3

c(zu  f)


c(f)
 Pricing Foreign Equity Options 943

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