Pricing currency options under two-factor Markov-modulated stochastic volatility models

Tak Kuen Siu, Hailiang Yang and John W. Lau

Insurance: Mathematics and Economics, 2008, vol. 43, issue 3, 295-302

Abstract: This article investigates the valuation of currency options when the dynamic of the spot Foreign Exchange (FX) rate is governed by a two-factor Markov-modulated stochastic volatility model, with the first stochastic volatility component driven by a lognormal diffusion process and the second independent stochastic volatility component driven by a continuous-time finite-state Markov chain model. The states of the Markov chain can be interpreted as the states of an economy. We employ the regime-switching Esscher transform to determine a martingale pricing measure for valuing currency options under the incomplete market setting. We consider the valuation of the European-style and American-style currency options. In the case of American options, we provide a decomposition result for the American option price into the sum of its European counterpart and the early exercise premium. Numerical results are included.

Keywords: Currency; options; Two-factor; stochastic; volatility; Regime; switching; Esscher; transform; Decomposition (search for similar items in EconPapers)
Date: 2008
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Citations: View citations in EconPapers (31)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:insuma:v:43:y:2008:i:3:p:295-302

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