EXPANSION FORMULAS FOR EUROPEAN QUANTO OPTIONS IN A LOCAL VOLATILITY FX-LIBOR MODEL

Julien Hok (), Philip Ngare () and Antonis Papapantoleon
Additional contact information
Julien Hok: Credit Agricole CIB, Broadwalk House, 5 Appold St, EC2A 2DA London, UK
Philip Ngare: #x2020;School of Mathematics, University of Nairobi, P.O. Box 30197-0010, Nairobi, Kenya
Antonis Papapantoleon: #x2021;Department of Mathematics, National Technical University of Athens, Zografou Campus, 15780 Athens, Greece

International Journal of Theoretical and Applied Finance (IJTAF), 2018, vol. 21, issue 02, 1-43

Abstract: We develop an expansion approach for the pricing of European quanto options written on LIBOR rates (of a foreign currency). We derive the dynamics of the system of foreign LIBOR rates under the domestic forward measure and then consider the price of the quanto option. In order to take the skew/smile effect observed in fixed income and FX markets into account, we consider local volatility models for both the LIBOR and the FX rate. Because of the structure of the local volatility function, a closed form solution for quanto option prices does not exist. Using expansions around a proxy related to log-normal dynamics, we derive approximation formulas of Black–Scholes type for the price, that have the benefit of giving very rapid numerical procedures. Our expansion formulas have the major advantage that they allow for an accurate estimation of the error, using Malliavin calculus, which is directly related to the maturity of the option, the payoff, and the level and curvature of the local volatility function. These expansions also illustrate the impact of the quanto drift adjustment, while the numerical experiments show an excellent accuracy.

Keywords: European quanto derivatives; convexity adjustment; volatility skew/smile; local volatility FX-LIBOR model; expansion formula; analytical approximations; Malliavin calculus (search for similar items in EconPapers)
Date: 2018
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Citations: View citations in EconPapers (4)

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DOI: 10.1142/S0219024918500176

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