Pricing Quanto Equity Swaps in a Stochastic Interest Rate Economy

San-Lin Chung and Hsiao-Fen Yang

Applied Mathematical Finance, 2005, vol. 12, issue 2, 121-146

Abstract: This paper derives a pricing model for a quanto foreign equity/domestic floating rate swap in which one party pays domestic floating interest rates and receives foreign stock returns determined in the foreign currency, but is paid in the domestic currency. We use the risk-neutral valuation technique developed by Amin and Bodurtha to generate an arbitrage-free pricing model. A closed-form solution is obtained under further restrictions on the drift rates of the asset price processes. Pricing formulae show that the value of a quanto equity swap at the start date does not depend on the foreign stock price level, but rather on the term structures of both countries and other parameters. However, the foreign stock price levels do affect the swap value times between two payment dates. The numerical implementations indicate that the domestic and foreign term structures, the correlation between the foreign interest rate and the exchange rate, and the correlation between the exchange rate and the foreign stock are more important factors in pricing a quanto equity swap than other correlations.

Keywords: Equity swaps; term structure of interest rates; risk-neutral valuation; arbitrage-free pricing model (search for similar items in EconPapers)
Date: 2005
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DOI: 10.1080/1350486042000297261

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