Article published by Jan Baldeaux, Martino Grasselli and Eckhard Platen in the Journal of Banking & Finance of Elsevier in April 2015. Martino Grasselli is professor of financial engineering at ESILV and head of Devinci Research Center – Finance Group at Pôle Léonard de Vinci.
This paper considers the realistic modelling of derivative contracts on exchange rates.
We propose a stochastic volatility model that recovers not only the typically observed implied volatility smiles and skews for short dated vanilla foreign exchange options but allows one also to price payoffs in foreign currencies, lower than possible under classical risk neutral pricing, in particular, for long dated derivatives.
The main reason for this important feature is the strict supermartingale property of benchmarked savings accounts under the real world probability measure, which the calibrated parameters identify under the proposed model.
Using a real dataset on vanilla option quotes, we calibrate our model on a triangle of currencies and find that the risk neutral approach fails for the calibrated model, while the benchmark approach still works.
Learn more about Martino Grasselli
Learn more about the Devinci Research Center – Finance Group: www.devinci.fr