Advanced Derivatives Modelling

Seminar 1: No-arbitrage pricing in FX markets

FX Quanto options

The payoff of a quanto call option at expity T can be described as:

h
i
C(T ) = max XSTf K, 0
in which STf denotes the price of a foreign stock at time T and X is a fixed exchange rate.
The stock pays a continuously compounded dividend yield q.
Question.
Calculate the price at time 0 of the quanto call option. You may assume that the risk-free
rates and the volatilities of both the stock and the foreign exchange rate are constants.
Implement the pricing formulae for the call options on a foreign asset that are
struck in foreign currency or
struck in domestic currency.
Question.
Take the strike of the option struck in foreign currency to be K and take the strike of the
option struck in domestic currency to be X0 K (so K is interpreted as an amount in foreign
currency). Calculate the option prices for S0f = 100 and K {50, 55, . . . , 150} and plot
them with K in the horizontal axis. You should be able to confirm, for example, that if
rd = rf and 0 then the option struck in domestic currency is more valuable for all
strikes.

Foreign exchange modelling: No-arbitrage pricing in the

domestic and foreign markets

Let Mtd and Mtf be the money market accounts in the domestic and foreign economies,
respectively. These are risk-free investments within the corresponding economies (i.e. when
expressed in their own currencies). Their dynamics are given by
dMtd = rd Mtd dt
dMtf

= rf Mtf dt

Let Xt be the foreign exchange rate that converts 1 unit of the foreign currency into the
domestic currency. In other words, Xt is the value of 1 unit of foreign currency expressed
in the domestic currency. Then, Yt = Mtf Xt is the value at time t of the foreign money
market account expressed in the domestic currency. Assume that the risk-neutral dynamics
of the foreign exchange rate are
dXt = Xt [dt + dWt ]

2.1

No-arbitrage dynamics in Domestic risk-neutral measure

Question.
Derive the stochastic differential equation for the process followed by Yt , and deduce the
risk-neutral drift of Xt under the domestic risk-neutral measure.
Derive the stochastic differential equation for the process followed by the inverse exchange
rate Zt = X1t under the domestic risk-neutral measure.

2.2

No-arbitrage dynamics in Foreign risk-neutral measure

Question.
What is the stochastic differential equation for Zt under the foreign risk-neutral measure?
Justify your answer.
What is the change of probability measure density for switching from the domestic to foreign
risk-neutral measures? Using Girsanov theorem, verify that your answer above (s.d.e for
Zt under the foreign risk-neutral measure) is correct.
Derive the stochastic differential equation for a foreign stock in the domestic risk-neutral
measure.

2.3

Pricing vanilla FX call

Question.
What is the formula for a vanilla option on the exchange rate with payoff max (XT K, 0)?