mafs5030 quantitative modeling of derivative securities
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1 MAFS5030 Quantitative Modeling of Derivative Securities
Tutorial Note 4
MAFS5030 Quantitative Modeling of Derivative Securities
Tutorial Note 4
Review on pricing technique in continuous time model (with multiple
assets)
In this tutorial, we shall review some important techniques in pricing derivatives
involving more than one stochastic random variables/ underlying assets. One difficulty
in pricing such derivatives is that the calculation involves the computation of
expectation involving several correlated random variables. One needs to employ various
methods/theorems so that one can compute the price in an easier way. The following
summarizes some useful theorems/methods for this purpose:
Girsanov Theorem (Describe the price dynamic of the underlying asset when the
probability measure is changed from 𝑃 to �̃�)
Numeraire invariance theorem (Describe the pricing formula of a contingent
claim when there is a change in numeraire)
Quanto prewashing technique (A method to determine the drift rate of the
target state variable under some probability measure in pricing quanto options).
Example 1 (Pricing of exchange options: A quick review)
We consider an exchange options (European) which the holder has the right to
exchange 𝐾 units of asset 𝑋 for one units of asset 𝑌. We let 𝑇 be the maturity date
of the options. The terminal payoff of the options is seen to be
𝑉𝑇(𝑋𝑇, 𝑌𝑇) = max(𝑌𝑇 − 𝐾𝑋𝑇 , 0), where 𝑋𝑇 and 𝑌𝑇 are prices of assets 𝑋 and 𝑌 at maturity date 𝑇 respectively. We
assume that the price processes of two assets are governed by
𝑑𝑋𝑡 = (𝑟 − 𝑞𝑋)𝑋𝑡𝑑𝑡 + 𝜎𝑋𝑋𝑡𝑑𝑍𝑋,𝑡𝑄 ,
𝑑𝑌𝑡 = (𝑟 − 𝑞𝑌)𝑌𝑡𝑑𝑡 + 𝜎𝑌𝑌𝑡𝑑𝑍𝑌,𝑡𝑄 ,
where 𝑍𝑋,𝑡𝑄 and 𝑍𝑌,𝑡
𝑄 are 𝑄-Brownian with 𝑑𝑍𝑋,𝑡𝑄 𝑑𝑍𝑌,𝑡
𝑄 = 𝜌𝑑𝑡.
Given the current prices of two assets 𝑋𝑡 and 𝑌𝑡, compute the current price of the
exchange options.
Solution
We take �̂�𝑡 = 𝑒𝑞𝑋𝑡𝑋𝑡 as the numeraire (recall that the asset 𝑋 pays continuous dividend
at the yield rate 𝑞𝑋). Using numeraire invariance theorem, the current price of the
exchange options can be expressed as
2 MAFS5030 Quantitative Modeling of Derivative Securities
Tutorial Note 4
𝑉𝑡 = 𝑒−𝑟(𝑇−𝑡)𝔼𝑄[𝑉𝑇(𝑋𝑇 , 𝑌𝑇)|ℱ𝑡] = 𝑀𝑡𝔼
𝑄 [𝑉𝑇(𝑋𝑇, 𝑌𝑇)
𝑀𝑇|ℱ𝑡] = �̂�𝑡𝔼
𝑄𝑋 [𝑉𝑇(𝑋𝑇, 𝑌𝑇)
�̂�𝑇|ℱ𝑡]
= 𝑒𝑞𝑋𝑡𝑋𝑡𝔼𝑄𝑋 [
max(𝑌𝑇 − 𝐾𝑋𝑇 , 0)
𝑒𝑞𝑋𝑇𝑋𝑇|ℱ𝑡]
= 𝑋𝑡 𝑒−𝑞𝑋(𝑇−𝑡)𝔼𝑄𝑋 [max (
𝑌𝑇𝑋𝑇− 𝐾) |ℱ𝑡]
⏟ 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑜𝑝𝑡𝑖𝑜𝑛𝑠 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡
(𝑚𝑒𝑎𝑠𝑢𝑟𝑒𝑑 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 𝑋)
……(∗)
To calculate the expectation 𝔼𝑄𝑋 [max (𝑌𝑇
𝑋𝑇− 𝐾) |ℱ𝑡], we need to know the
“distribution” of the random variable 𝑌𝑇
𝑋𝑇 under 𝑄𝑋.
By applying Ito’s lemma on the function 𝑓(𝑋𝑡, 𝑌𝑡) =𝑌𝑡
𝑋𝑡, we get
𝑑 (𝑌𝑡𝑋𝑡) =
[
(𝑟 − 𝑞𝑋)𝑋𝑡𝜕𝑓
𝜕𝑋𝑡+ (𝑟 − 𝑞𝑌)𝑌𝑡
𝜕𝑓
𝜕𝑌𝑡⏟
∑ 𝜇𝑖𝜕𝑓𝜕𝑋𝑖
𝑛𝑖=1
+1
2𝜎𝑋2𝑋𝑡
2𝜕2𝑓
𝜕𝑋𝑡2 + 𝜌𝜎𝑋𝜎𝑌𝑋𝑡𝑌𝑡
𝜕2𝑓
𝜕𝑋𝑡𝜕𝑌𝑡+1
2𝜎𝑌2𝑌𝑡
2𝜕2𝑓
𝜕𝑌𝑡2
⏟ 12∑ ∑ 𝜎𝑖𝜎𝑗
𝜕2𝑓𝜕𝑋𝑖𝜕𝑋𝑗
𝑛𝑗=1
𝑛𝑖=1 ]
𝑑𝑡 + 𝜎𝑋𝑋𝑡𝜕𝑓
𝜕𝑋𝑡𝑑𝑍𝑋,𝑡
𝑄
+ 𝜎𝑌𝑌𝑡𝜕𝑓
𝜕𝑌𝑡𝑑𝑍𝑌,𝑡
𝑄 .
⇒ 𝑑 (𝑌𝑡𝑋𝑡) = [(𝑟 − 𝑞𝑋)𝑋𝑡 (−
𝑌𝑡
𝑋𝑡2) + (𝑟 − 𝑞𝑌)𝑌𝑡 (
1
𝑋𝑡) +
1
2𝜎𝑋2𝑋𝑡
2 (2𝑌𝑡
𝑋𝑡3)
+ 𝜌𝜎𝑋𝜎𝑌𝑋𝑡𝑌𝑡 (−1
𝑋𝑡2) +
1
2𝜎𝑌2𝑌𝑡
2(0)] 𝑑𝑡 + 𝜎𝑋𝑋𝑡 (−𝑌𝑡
𝑋𝑡2)𝑑𝑍𝑋,𝑡
𝑄
+ 𝜎𝑌𝑌𝑡 (1
𝑋𝑡)𝑑𝑍𝑌,𝑡
𝑄
⇒ 𝑑 (𝑌𝑡𝑋𝑡) = [(𝑟 − 𝑞𝑌) − (𝑟 − 𝑞𝑋) + 𝜎𝑋
2 − 𝜌𝜎𝑋𝜎𝑌]𝑌𝑡𝑋𝑡𝑑𝑡 − 𝜎𝑋
𝑌𝑡𝑋𝑡𝑑𝑍𝑋,𝑡
𝑄 + 𝜎𝑌𝑌𝑡𝑋𝑡𝑑𝑍𝑌,𝑡
𝑄
By taking 𝑊𝑡 =𝑌𝑡
𝑋𝑡, we get
Unfortunately, the above equation is not useful because the random variables 𝑍𝑋,𝑡𝑄 and
𝑍𝑌,𝑡𝑄 are no longer to be the Brownian motion under 𝑄𝑋.
Step 1: Compute the price dynamic of 𝑌𝑡/𝑋𝑡
𝑑𝑊𝑡 = [(𝑟 − 𝑞𝑌) − (𝑟 − 𝑞𝑋) + 𝜎𝑋2 − 𝜌𝜎𝑋𝜎𝑌]𝑊𝑡𝑑𝑡 − 𝜎𝑋𝑊𝑡𝑑𝑍𝑋,𝑡
𝑄 + 𝜎𝑌𝑊𝑡𝑑𝑍𝑌,𝑡𝑄
3 MAFS5030 Quantitative Modeling of Derivative Securities
Tutorial Note 4
To do this, we shall use Girsanov theorem. Firstly, the Radon-Nikodym derivative is
given by
𝐿𝑡 =𝑑𝑄𝑋𝑑𝑄
|ℱ0 =�̂�𝑡/�̂�0𝑀𝑡/𝑀0
=⏞
�̂�𝑡=𝑋𝑡𝑒𝑞𝑋𝑡
𝑀𝑡=𝑒𝑟𝑡 𝑋𝑡𝑒
𝑞𝑋𝑡
𝑋0𝑒𝑟𝑡
1
=
𝑋0𝑒(𝑟−𝑞𝑋−
𝜎𝑋2
2)𝑡+𝜎𝑋𝑍𝑋,𝑡
𝑄
𝑒𝑞𝑋𝑡
𝑋0𝑒𝑟𝑡
= 𝑒−𝜎𝑋2
2𝑡+𝜎𝑋𝑍𝑋,𝑡
𝑄
= 𝑒∫ −(−𝜎𝑋)𝑑𝑍𝑋,𝑡𝑄𝑡
0−12∫
(−𝜎𝑋)2𝑑𝑠
𝑡0 .
By taking 𝛾(𝑡) = −𝜎𝑋, one can deduce from Girsanov’s theorem that the process
𝑍𝑋,𝑡𝑄𝑋 = 𝑍𝑋,𝑡
𝑄 +∫ 𝛾(𝑠)𝑑𝑠𝑡
0
= 𝑍𝑋,𝑡𝑄 − 𝜎𝑋𝑡
is a 𝑄𝑋-Brownian.
It remains to get a corresponding 𝑄𝑋-Brownian for 𝑍𝑌,𝑡𝑄 . From the result in the Lecture
Note (I skipped the details here), we get that the process
𝑍𝑌,𝑡𝑄𝑋 = 𝑍𝑌,𝑡
𝑄 − 𝜌𝜎𝑋𝑡,
is also a 𝑄𝑋-Brownian with 𝑑𝑍𝑋,𝑡𝑄𝑋(𝑑𝑍𝑌,𝑡
𝑄𝑋) = 𝜌𝑑𝑡.
Using 𝑄𝑋, the price dynamic of 𝑑𝑊𝑡 can now be expressed as
𝑑𝑊𝑡 = [(𝑟 − 𝑞𝑌) − (𝑟 − 𝑞𝑋) + 𝜎𝑋2 − 𝜌𝜎𝑋𝜎𝑌]𝑊𝑡𝑑𝑡 − 𝜎𝑋𝑊𝑡𝑑 (𝑍𝑋,𝑡
𝑄 + 𝜎𝑋𝑡)⏟
𝑍𝑋,𝑡𝑄
+ 𝜎𝑌𝑊𝑡𝑑 (𝑍𝑌,𝑡𝑄𝑋 + 𝜌𝜎𝑋𝑡)⏟
𝑍𝑌,𝑡𝑄
Hence, we get
Note that the sum −𝜎𝑋𝑊𝑡𝑑𝑍𝑋,𝑡𝑄𝑋 + 𝜎𝑌𝑊𝑡𝑑𝑍𝑌,𝑡
𝑄𝑋 is normally distributed with mean 0 and
variance (𝜎𝑋2 − 2𝜌𝜎𝑋𝜎𝑌 + 𝜎𝑌
2)𝑊𝑡2𝑑𝑡. So we can write the above equation as
where 𝑍𝑡𝑄𝑋 is 𝑄𝑋-Brownian.
Step 2: Replace 𝑍𝑋,𝑡𝑄 and 𝑍𝑌,𝑡
𝑄 by two 𝑄𝑋-Brownians
𝑑𝑊𝑡 = (𝑞𝑋 − 𝑞𝑌)𝑊𝑡𝑑𝑡 − 𝜎𝑋𝑊𝑡𝑑𝑍𝑋,𝑡𝑄𝑋 + 𝜎𝑌𝑊𝑡𝑑𝑍𝑌,𝑡
𝑄𝑋
𝑑𝑊𝑡 = (𝑞𝑋 − 𝑞𝑌)𝑊𝑡𝑑𝑡 + √(𝜎𝑋2 − 2𝜌𝜎𝑋𝜎𝑌 + 𝜎𝑌
2)⏟
𝜎𝑊
𝑊𝑡𝑑𝑍𝑡𝑄𝑋
4 MAFS5030 Quantitative Modeling of Derivative Securities
Tutorial Note 4
Given the current value of 𝑋𝑡, 𝑌𝑡 (so that 𝑊𝑡 =𝑌𝑡
𝑋𝑡 is known), the value of 𝑊𝑇 at maturity
date 𝑇 can now be expressed as
𝑊𝑇 = 𝑊𝑡𝑒(𝑞𝑋−𝑞𝑌−
𝜎𝑊2
2)(𝑇−𝑡)+𝜎𝑊𝑍𝑇−𝑡
𝑄𝑋
.
Note that
𝑊𝑇 =𝑌𝑇𝑋𝑇> 𝐾 ⇔ 𝑍𝑇−𝑡
𝑄𝑋 >ln𝐾𝑊𝑡− (𝑞𝑋 − 𝑞𝑌 −
𝜎𝑊2
2 )(𝑇 − 𝑡)
𝜎𝑊⏟ 𝑑𝑒𝑛𝑜𝑡𝑒𝑑 𝑏𝑦 𝑑
From equation (∗), the time-𝑡 price of the exchange options can now be expressed as
𝑉𝑡 = 𝑋𝑡𝑒−𝑞𝑋(𝑇−𝑡)𝔼𝑄𝑋 [max (
𝑌𝑇𝑋𝑇− 𝐾) |ℱ𝑡] = 𝑋𝑡𝑒
−𝑞𝑋(𝑇−𝑡)𝔼𝑄𝑋[max(𝑊𝑇 − 𝐾) |ℱ𝑡]
= 𝑋𝑡𝑒−𝑞𝑋(𝑇−𝑡) [∫ (𝑊𝑡𝑒
(𝑞𝑋−𝑞𝑌−𝜎𝑊2
2)(𝑇−𝑡)+𝜎𝑊𝑧
−𝐾)(1
√2𝜋(𝑇 − 𝑡)𝑒−
𝑧2
2(𝑇−𝑡))𝑑𝑧∞
𝑑
+∫ (0) (1
√2𝜋(𝑇 − 𝑡)𝑒−
𝑧2
2(𝑇−𝑡))𝑑𝑧𝑑
−∞
]
= 𝑋𝑡𝑒−𝑞𝑋(𝑇−𝑡) [∫ 𝑊𝑡𝑒
(𝑞𝑋−𝑞𝑌−𝜎𝑊2
2)(𝑇−𝑡)+𝜎𝑊𝑧
(1
√2𝜋(𝑇 − 𝑡)𝑒−
𝑧2
2(𝑇−𝑡))𝑑𝑧∞
𝑑
− 𝐾∫ (1
√2𝜋(𝑇 − 𝑡)𝑒−
𝑧2
2(𝑇−𝑡))𝑑𝑧∞
𝑑
]
= 𝑋𝑡𝑒−𝑞𝑋(𝑇−𝑡) [𝑊𝑡𝑒
(𝑞𝑋−𝑞𝑌)(𝑇−𝑡)∫ (1
√2𝜋(𝑇 − 𝑡)𝑒−(𝑧−𝜎𝑊(𝑇−𝑡))
2
2(𝑇−𝑡) )𝑑𝑧∞
𝑑
− 𝐾∫ (1
√2𝜋(𝑇 − 𝑡)𝑒−12(
𝑧
√𝑇−𝑡)2
)𝑑𝑧∞
𝑑
]
=⏞
𝑧1=𝑧−𝜎𝑊(𝑇−𝑡)
√𝑇−𝑡
𝑧2=𝑧
√𝑇−𝑡
𝑋𝑡𝑒−𝑞𝑋(𝑇−𝑡) [𝑊𝑡𝑒
(𝑞𝑋−𝑞𝑌)(𝑇−𝑡)∫ (1
√2𝜋𝑒−
𝑧12
2 )𝑑𝑧1
∞
𝑑−𝜎𝑊(𝑇−𝑡)
√𝑇−𝑡
− 𝐾∫ (1
√2𝜋𝑒−
𝑧22 )𝑑𝑧2
∞
𝑑
√𝑇−𝑡
]
Step 3: Obtain the price process of 𝑊𝑡 under 𝑄𝑋
Step 4: Obtain the pricing formula
5 MAFS5030 Quantitative Modeling of Derivative Securities
Tutorial Note 4
= 𝑋𝑡𝑒−𝑞𝑋(𝑇−𝑡)𝑊𝑡𝑒
(𝑞𝑋−𝑞𝑌)(𝑇−𝑡) [1 − 𝑁 (𝑑 − 𝜎𝑊(𝑇 − 𝑡)
√𝑇 − 𝑡)]
− 𝐾𝑋𝑡𝑒−𝑞𝑋(𝑇−𝑡) [1 − 𝑁 (
𝑑
√𝑇 − 𝑡)]
= 𝑋𝑡𝑒−𝑞𝑋(𝑇−𝑡) (
𝑌𝑡𝑋𝑡) 𝑒(𝑞𝑋−𝑞𝑌)(𝑇−𝑡) [𝑁 (−
𝑑 − 𝜎𝑊(𝑇 − 𝑡)
√𝑇 − 𝑡)]
− 𝐾𝑋𝑡𝑒−𝑞𝑋(𝑇−𝑡) [𝑁 (−
𝑑
√𝑇 − 𝑡)]
= 𝑌𝑡𝑒−𝑞𝑌(𝑇−𝑡)𝑁(𝑑1) − 𝐾𝑋𝑡𝑒
−𝑞𝑋(𝑇−𝑡)𝑁(𝑑2),
where
𝑑1 = −𝑑 − 𝜎𝑊(𝑇 − 𝑡)
√𝑇 − 𝑡=ln (
𝑌𝑡𝐾𝑋𝑡
) + (𝑞𝑋 − 𝑞𝑌 +𝜎𝑊2
2 )(𝑇 − 𝑡)
𝜎𝑊√𝑇 − 𝑡
𝑑2 = −𝑑
√𝑇 − 𝑡=ln (
𝑌𝑡𝐾𝑋𝑡
) + (𝑞𝑋 − 𝑞𝑌 −𝜎𝑊2
2 )(𝑇 − 𝑡)
𝜎𝑊√𝑇 − 𝑡
Example 2 (Quantos digital options)
(a) We consider a quanto on a foreign currency denominated asset which pays
holder an amount 𝐹𝑇 (1 unit of foreign currency) at the maturity date 𝑇 if the
asset price 𝑆𝑇 is above 𝑋𝑓 and nothing if otherwise. So the terminal payoff of
the options can be expressed as
𝑉𝑇(𝑆𝑇, 𝐹𝑇) = {𝐹𝑇 𝑖𝑓 𝑆𝑇 ≥ 𝑋𝑓
0 𝑖𝑓 𝑆𝑇 < 𝑋𝑓.
Here, 𝐹𝑇 denotes the exchange rate for the foreign currency and 𝑆𝑇 is the
price (measured in foreign currency) of the underlying asset. We assume that
both 𝐹𝑇 and 𝑆𝑇 are governing by Geometric Brownian motion.
Given the value of 𝐹𝑡 and 𝑆𝑡, what is the time-𝑡 price of the options?
(b) We consider a quanto on a foreign currency denominated asset which pays
holder an amount 𝐹𝑇 (1 unit of foreign currency) at the maturity date 𝑇 if the
asset price 𝑆𝑇 is above 𝑋𝑓 and nothing if otherwise. So the terminal payoff of
the options can be expressed as
𝑉𝑇(𝑆𝑇, 𝐹𝑇) = {1 𝑖𝑓 𝑆𝑇 ≥ 𝑋𝑓
0 𝑖𝑓 𝑆𝑇 < 𝑋𝑓.
Here, 𝐹𝑇 denotes the exchange rate for the foreign currency and 𝑆𝑇 is the
price (measured in foreign currency) of the underlying asset. What is the
corresponding time-𝑡 price of the options?
6 MAFS5030 Quantitative Modeling of Derivative Securities
Tutorial Note 4
Some notations:
We let 𝑄𝑑 and 𝑄𝑓 be the risk neutral probability measure under domestic
currency and foreign currency respectively.
We let 𝑟𝑑 and 𝑟𝑓 be the risk-free interest rate of domestic currency and foreign
currency respectively.
Solution of (a)
Assuming the options is attainable, the time-𝑡 price of the quanto options can be
expressed, using risk neutral valuation principle, as
𝑉𝑡(𝑆𝑡, 𝐹𝑡) = 𝑒−𝑟𝑑(𝑇−𝑡)𝔼𝑄𝑑[𝑉𝑇(𝑆𝑇, 𝐹𝑇)|ℱ𝑡] = 𝑒
−𝑟𝑑(𝑇−𝑡)𝔼𝑄𝑑 [𝐹𝑇𝟏{𝑆𝑇>𝑋𝑓}|ℱ𝑡].
We take 𝑁(𝑡) = 𝑒𝑟𝑓𝑡𝐹𝑡 as the numeraire (*Here, 𝑁𝑡 is the value of one unit of foreign
currency bought at time 0). Using numeraire invariance theorem, we deduce that
𝑉𝑡(𝑆𝑡, 𝐹𝑡) = 𝑒−𝑟𝑑(𝑇−𝑡)𝔼𝑄𝑑 [𝐹𝑇𝟏{𝑆𝑇>𝑋𝑓}|ℱ𝑡] =⏞
𝑀𝑑(𝑡)=𝑒𝑟𝑑𝑡
𝑀𝑑(𝑡)
𝑀𝑑(𝑇)𝔼𝑄𝑑 [𝐹𝑇𝟏{𝑆𝑇>𝑋𝑓}|ℱ𝑡]
= 𝑀𝑑(𝑡)𝔼𝑄𝑑 [
𝐹𝑇𝟏{𝑆𝑇>𝑋𝑓}
𝑀𝑑(𝑇)|ℱ𝑡] =
(∗) 𝑁(𝑡)𝔼𝑄𝑓 [𝐹𝑇𝟏{𝑆𝑇>𝑋𝑓}
𝑁(𝑇)|ℱ𝑡]
= 𝑒𝑟𝑓𝑡𝐹𝑡𝔼𝑄𝑓 [
𝐹𝑇𝟏{𝑆𝑇>𝑋𝑓}
𝑒𝑟𝑓𝑇𝐹𝑇|ℱ𝑡] = 𝑒
−𝑟𝑓(𝑇−𝑡)𝐹𝑡𝔼𝑄𝑓 [𝟏{𝑆𝑇>𝑋𝑓}|ℱ𝑡].
So we get
To calculate the expectation, we need to obtain the price dynamic of 𝑆𝑇 under the
probability measure 𝑄𝑓.
Since 𝑆𝑡 is assumed to follow Geometric Brownian Motion and its value is in foreign
currency, so under risk neutral probability measure 𝑄𝑓 (in foreign currency world), 𝑆𝑡
should follow:
Here, 𝑞 is dividend yield rate of the asset (𝑞 = 0 if the asset is non-dividend paying) and
𝜎𝑆 is the volatility of the asset.
IDEA: It may be difficult to compute the expectation directly since we need to
handle two correlated random variables (𝐹𝑇 , 𝑆𝑇) simultaneously. The computation
would be easier if we apply change of numeraire technical by taking the foreign
currency as the numeraire.
𝑉𝑡(𝑆𝑡, 𝐹𝑡) = 𝑒−𝑟𝑓(𝑇−𝑡)𝐹𝑡𝔼
𝑄𝑓 [𝟏{𝑆𝑇>𝑋𝑓}|ℱ𝑡]
𝑑𝑆𝑡 = (𝑟𝑓 − 𝑞)𝑆𝑡𝑑𝑡 + 𝜎𝑆𝑆𝑡𝑑𝑍𝑡𝑄𝑓 .
7 MAFS5030 Quantitative Modeling of Derivative Securities
Tutorial Note 4
Given the current value of 𝑆𝑡, the asset price at the maturity date can be expressed as
𝑆𝑇 = 𝑆𝑡𝑒(𝑟𝑓−𝑞−
𝜎𝑆2
2)(𝑇−𝑡)+𝜎𝑆𝑍𝑇−𝑡
𝑄𝑓
.
Together with the fact that 𝑍𝑇−𝑡𝑄𝑓 is normally distributed with mean 0 and variance 𝑇 − 𝑡
and the fact that
𝑆𝑇 > 𝑋𝑓 ⇔ 𝑍𝑇−𝑡𝑄𝑓 >
ln𝑋𝑓𝑆𝑡− (𝑟𝑓 − 𝑞 −
𝜎𝑆2
2 )(𝑇 − 𝑡)
𝜎𝑆⏟ 𝑑
the expectation can be computed as
𝔼𝑄𝑓 [𝟏{𝑆𝑇>𝑋𝑓}|ℱ𝑡] = ∫ (1)1
√2𝜋(𝑇 − 𝑡)𝑒−
𝑧2
2(𝑇−𝑡)𝑑𝑧∞
𝑑
=⏞
𝑦=𝑧
√𝑇−𝑡
∫1
√2𝜋𝑒−
𝑦2
2 𝑑𝑦∞
𝑑
√𝑇−𝑡
= 1 − 𝑁 (𝑑
√𝑇 − 𝑡) = 𝑁 (−
𝑑
√𝑇 − 𝑡)
= 𝑁
(
ln𝑆𝑡𝑋𝑓+ (𝑟𝑓 − 𝑞 −
𝜎𝑆2
2 )(𝑇 − 𝑡)
𝜎𝑆√𝑇 − 𝑡⏟ =𝑑1 )
.
Hence, the time-𝑡 price of the quanto options is
𝑉𝑡(𝑆𝑡, 𝐹𝑡) = 𝑒−𝑟𝑓(𝑇−𝑡)𝐹𝑡𝔼
𝑄𝑓 [𝟏{𝑆𝑇>𝑋𝑓}|ℱ𝑡] = 𝑒−𝑟𝑓(𝑇−𝑡)𝐹𝑡𝑁(𝑑1).
Solution of (b)
Using risk neutral valuation principle, the time-𝑡 price of the quanto options can be
expressed, using risk neutral valuation principle, as
𝑉𝑡(𝑆𝑡, 𝐹𝑡) = 𝑒−𝑟𝑑(𝑇−𝑡)𝔼𝑄𝑑[𝑉𝑇(𝑆𝑇, 𝐹𝑇)|ℱ𝑡] = 𝑒
−𝑟𝑑(𝑇−𝑡)𝔼𝑄𝑑 [𝟏{𝑆𝑇>𝑋𝑓}|ℱ𝑡].
Recall that the price dynamic of 𝑆𝑇 under 𝑄𝑓 is
𝑑𝑆𝑡𝑆𝑡= (𝑟𝑓 − 𝑞)𝑑𝑡 + 𝜎𝑆𝑑𝑍𝑆,𝑡
𝑄𝑓 .
Using Girsanov’s theorem, the corresponding price process of 𝑆𝑇 under 𝑄𝑑 is given by 𝑑𝑆𝑡𝑆𝑡= 𝛿𝑆
𝑑𝑑𝑡 + 𝜎𝑆𝑑𝑍𝑆,𝑡𝑄𝑑 .
Here, 𝑍𝑆,𝑡𝑄𝑑 is standard Brownian motion under 𝑄𝑑.
IDEA: To calculate the expectation, we need to obtain the price dynamic of 𝑆𝑇
under 𝑄𝑑 (in domestic world). To do so, we shall apply the quanto prewashing
technique.
8 MAFS5030 Quantitative Modeling of Derivative Securities
Tutorial Note 4
We note the followings:
Using risk neutral probability measure 𝑄𝑑, the price process 𝑆𝑡∗ = 𝑆𝑡𝐹𝑡 (price of
the asset under domestic currency) should have a drift rate 𝛿𝑆∗𝑑 = 𝑟𝑑 − 𝑞
Under risk neutral probability measure 𝑄𝑑, the price process 𝐹𝑡 should satisfy 𝑑𝐹𝑡𝐹𝑡= (𝑟𝑑 − 𝑟𝑓)𝑑𝑡 + 𝜎𝐹𝑑𝑍𝐹,𝑡
𝑄𝑑 .
Here, 𝑍𝐹,𝑡𝑄𝑑 is standard Brownian motion under 𝑄𝑑. We assume that
(𝑑𝑍𝑆,𝑡𝑄𝑑)(𝑑𝑍𝐹,𝑡
𝑄𝑑) = 𝜌𝑑𝑡.
By applying Ito’s lemma on the function 𝑓(𝑆𝑡, 𝐹𝑡) = 𝑆𝑡𝐹𝑡, we obtain
𝑑(𝑆𝑡𝐹𝑡) = (0 + 𝐹𝑡(𝛿𝑑𝑆𝑆𝑡) + 𝑆𝑡(𝑟𝑑 − 𝑟𝑓)𝐹𝑡 + 𝜌𝜎𝑆𝜎𝐹𝐹𝑡𝑆𝑡)𝑑𝑡 + 𝑆𝑡(𝜎𝐹𝐹𝑡)𝑑𝑍𝐹,𝑡
𝑄𝑑
+ 𝐹𝑡(𝜎𝑆𝑆𝑡)𝑑𝑍𝑆,𝑡𝑄𝑑
⇒ 𝑑(𝑆𝑡𝐹𝑡) = 𝑆𝑡𝐹𝑡[(𝛿𝑑𝑆 + 𝑟𝑑 − 𝑟𝑓 + 𝜌𝜎𝑆𝜎𝐹)𝑑𝑡 + 𝜎𝐹𝑑𝑍𝐹,𝑡
𝑄𝑑 + 𝜎𝑆𝑑𝑍𝑆,𝑡𝑄𝑑]
⇒𝑑𝑆𝑡
∗
𝑆𝑡∗ =
𝑑(𝑆𝑡𝐹𝑡)
𝑆𝑡𝐹𝑡= (𝛿𝑑
𝑆 + 𝑟𝑑 − 𝑟𝑓 + 𝜌𝜎𝑆𝜎𝐹)⏟ 𝛿𝑆∗𝑑
𝑑𝑡 + 𝜎𝐹𝑑𝑍𝐹,𝑡𝑄𝑑 + 𝜎𝑆𝑑𝑍𝑆,𝑡
𝑄𝑑 .
By comparing the drift rates, we have
𝛿𝑑𝑆 + 𝑟𝑑 − 𝑟𝑓 + 𝜌𝜎𝑆𝜎𝐹 = 𝑟𝑑 − 𝑞 ⇒ 𝛿𝑑
𝑆 = 𝑟𝑓 − 𝑞 − 𝜌𝜎𝑆𝜎𝐹.
The price process of the 𝑆𝑡 under 𝑄𝑑 is
Given the value of 𝑆𝑡, the asset price at the maturity date 𝑇 is
𝑆𝑇 = 𝑆𝑡𝑒(𝑟𝑓−𝑞−𝜌𝜎𝑆𝜎𝐹−
𝜎𝐹2
2)(𝑇−𝑡)+𝜎𝑆𝑍𝑆,𝑇−𝑡
𝑄𝑑
.
Using similar method as in (a), the expectation can be computed as
𝔼𝑄𝑑 [𝟏{𝑆𝑇>𝑋𝑓}|ℱ𝑡] = ∫ (1)1
√2𝜋(𝑇 − 𝑡)𝑒−
𝑧2
2(𝑇−𝑡)𝑑𝑧∞
𝑑′= ⋯ = 𝑁(−
𝑑′
√𝑇 − 𝑡) = 𝑁(𝑑1
′ ),
where 𝑑′ =ln𝑋𝑓
𝑆𝑡−(𝑟−𝑞−
𝜎𝑆2
2)(𝑇−𝑡)
𝜎𝑆 and 𝑑1
′ =ln𝑆𝑡𝑋𝑓+(𝑟𝑓−𝑞−𝜌𝜎𝑆𝜎𝐹−
𝜎𝑆2
2)(𝑇−𝑡)
𝜎𝑆√𝑇−𝑡.
Hence, the time-𝑡 price of this quanto options is given by
𝑉𝑡(𝑆𝑡, 𝐹𝑡) = 𝑒−𝑟𝑑(𝑇−𝑡)𝔼𝑄𝑑 [𝟏{𝑆𝑇>𝑋𝑓}|ℱ𝑡] = 𝑒
−𝑟𝑑(𝑇−𝑡)𝑁(𝑑1′ ).
How to determine 𝛿𝑆𝑑?
𝑑𝑆𝑡𝑆𝑡= (𝑟𝑓 − 𝑞 − 𝜌𝜎𝑆𝜎𝐹)𝑑𝑡 + 𝜎𝑆𝑑𝑍𝑆,𝑡
𝑄𝑑
9 MAFS5030 Quantitative Modeling of Derivative Securities
Tutorial Note 4
Example 3 (Two more examples on quanto options: A quick review)
(a) We consider a foreign equity call struck which the terminal payoff is given by
𝑉𝑇 = 𝐹𝑇max(𝑆𝑇 − 𝑋𝑓, 0).
Find the time-𝑡 price of the quanto options.
(b) We consider a fixed exchange rate foreign equity call which the terminal
payoff is given by
𝑉𝑇 = 𝐹0max(𝑆𝑇 − 𝑋𝑓, 0),
Where 𝐹0 is the predetermined fixed exchange rate. Find the time-𝑡 price of
the quanto options.
(*The notations used in this example is same as those used in Example 2)
Solution of (a)
The time-𝑡 price of the quanto options can be expressed, using risk neutral valuation
principle, as
𝑉𝑡(𝑆𝑡, 𝐹𝑡) = 𝑒−𝑟𝑑(𝑇−𝑡)𝔼𝑄𝑑[𝑉𝑇(𝑆𝑇 , 𝐹𝑇)|ℱ𝑡] = 𝑒
−𝑟𝑑(𝑇−𝑡)𝔼𝑄𝑑[𝐹𝑇max(𝑆𝑇 − 𝑋𝑓, 0) |ℱ𝑡].
Since the expectation involves two random variables, one shall simplify the expectation
using change of numeraire technique (take foreign currency 𝐹𝑡 as numeraire).
We take 𝑁𝑡 = 𝑒𝑟𝑓𝑡𝐹𝑡 as our numeraire. By numeraire invariance theorem, we deduce
that
𝑉𝑡(𝑆𝑡, 𝐹𝑡) = 𝑒−𝑟𝑑(𝑇−𝑡)𝔼𝑄𝑑[𝐹𝑇max(𝑆𝑇 − 𝑋𝑓 , 0) |ℱ𝑡]
=⏞𝑀𝑡=𝑒
𝑟𝑡𝑀𝑡𝑀𝑇
𝔼𝑄𝑑[𝐹𝑇max(𝑆𝑇 − 𝑋𝑓, 0) |ℱ𝑡]
= 𝑀𝑡𝔼𝑄𝑑 [
𝐹𝑇max(𝑆𝑇 − 𝑋𝑓 , 0)
𝑀𝑇|ℱ𝑡]
= 𝑁𝑡𝔼𝑄𝑓 [
𝐹𝑇max(𝑆𝑇 − 𝑋𝑓 , 0)
𝑁𝑇|ℱ𝑡] = 𝑒
𝑟𝑓𝑡𝐹𝑡𝔼𝑄𝑓 [
𝐹𝑇max(𝑆𝑇 − 𝑋𝑓 , 0)
𝑒𝑟𝑓𝑇𝐹𝑇|ℱ𝑡]
= 𝑒−𝑟𝑓(𝑇−𝑡)𝐹𝑡𝔼𝑄𝑓[max(𝑆𝑇 − 𝑋𝑓 , 0) |ℱ𝑡].
So we get
To calculate the above expectation, we observe that the term 𝑒−𝑟𝑓(𝑇−𝑡)𝔼𝑄𝑓[max(𝑆𝑇 −
𝑋𝑓 , 0) |ℱ𝑡] is simply the time-𝑡 price of the European call option on the foreign asset in
foreign currency. So we have
𝑒−𝑟𝑓(𝑇−𝑡)𝔼𝑄𝑓[max(𝑆𝑇 − 𝑋𝑓 , 0) |ℱ𝑡] = 𝑐𝑓(𝑆, 𝑡)
= 𝑆𝑡𝑒−𝑞(𝑇−𝑡)𝑁(𝑑1) − 𝑋𝑓𝑒
−𝑟𝑓(𝑇−𝑡)𝑁(𝑑2),
𝑉𝑡(𝑆𝑡, 𝐹𝑡) = 𝑒−𝑟𝑓(𝑇−𝑡)𝐹𝑡𝔼
𝑄𝑓[max(𝑆𝑇 − 𝑋𝑓 , 0) |ℱ𝑡]
10 MAFS5030 Quantitative Modeling of Derivative Securities
Tutorial Note 4
where
𝑑1 =
ln𝑆𝑡𝑋𝑓+ (𝑟𝑓 − 𝑞 +
𝜎𝑆2
2 )(𝑇 − 𝑡)
𝜎𝑆√𝑇 − 𝑡, 𝑑2 = 𝑑1 − 𝜎𝑆√𝑇 − 𝑡.
Solution of (b)
The time-𝑡 price of the quanto options can be expressed, using risk neutral valuation
principle, as
𝑉𝑡(𝑆𝑡, 𝐹𝑡) = 𝑒−𝑟𝑑(𝑇−𝑡)𝔼𝑄𝑑[𝑉𝑇(𝑆𝑇 , 𝐹𝑇)|ℱ𝑡] = 𝑒
−𝑟𝑑(𝑇−𝑡)𝔼𝑄𝑑[𝐹0max(𝑆𝑇 − 𝑋𝑓 , 0) |ℱ𝑡].
Since there is only one random variable in the expectation, we can compute the
expectation directly without using change of numeraire.
To compute the expectation, one needs to obtain the price dynamic of 𝑆𝑡 under risk
neutral probability measure 𝑄𝑑 (not 𝑄𝑓).
Using similar method as in Example 2(b), we get
Given the current value of 𝑆𝑡, the value of 𝑆𝑇 can be expressed as
𝑆𝑇 = 𝑆𝑡𝑒(𝛿𝑆
𝑑−𝜎𝑆2
2)(𝑇−𝑡)+𝜎𝑆𝑍𝑆,𝑇−𝑡
𝑄𝑑
. Note that
𝑆𝑇 > 𝑋 ⇔ 𝑍𝑆,𝑇−𝑡𝑄𝑑 >
ln𝑋𝑆𝑡− (𝛿𝑆
𝑑 −𝜎𝑆2
2 )(𝑇 − 𝑡)
𝜎𝑆⏟ 𝑑
.
Together with the fact that 𝑍𝑆,𝑇−𝑡𝑄𝑑 is normally distributed with mean 0 and variance 𝑇 −
𝑡, the fair price can be computed as
𝑉𝑡(𝑆𝑡, 𝐹𝑡) = 𝑒−𝑟𝑑(𝑇−𝑡)𝔼𝑄𝑑[𝐹0max(𝑆𝑇 − 𝑋𝑓, 0) |ℱ𝑡]
= 𝐹0𝑒−𝑟𝑑(𝑇−𝑡) [∫ (𝑆𝑡𝑒
(𝛿𝑆𝑑−𝜎𝑆2
2)(𝑇−𝑡)+𝜎𝑆𝑧
− 𝑋𝑓)(1
√2𝜋(𝑇 − 𝑡)𝑒−
𝑧2
2(𝑇−𝑡))𝑑𝑧∞
𝑑
]
= ⋯ = 𝐹0𝑒−𝑟𝑑(𝑇−𝑡) [𝑆𝑒𝛿𝑆
𝑑(𝑇−𝑡)𝑁(𝑑1) − 𝑋𝑓𝑁(𝑑2)],
where
𝑑1 =
ln𝑆𝑡𝑋𝑓+ (𝛿𝑆
𝑑 +𝜎𝑆2
2 )(𝑇 − 𝑡)
𝜎𝑆√𝑇 − 𝑡, 𝑑2 = 𝑑1 − 𝜎𝑆√𝑇 − 𝑡.
𝑑𝑆𝑡𝑆𝑡= 𝛿𝑆
𝑑𝑑𝑡 + 𝜎𝑆𝑑𝑍𝑆,𝑡𝑄𝑑 = (𝑟𝑓 − 𝑞 − 𝜌𝜎𝑆𝜎𝐹)𝑑𝑡 + 𝜎𝑆𝑑𝑍𝑆,𝑡
𝑄𝑑
11 MAFS5030 Quantitative Modeling of Derivative Securities
Tutorial Note 4
Example 4 (Problem 4 of 2013 Final)
We let 𝐹𝑆\𝑈 = 𝐹𝑆\𝑈(𝑡) denote the Singaporean currency price of 1 unit of US
currency and 𝐹𝐻\𝑆 denote the Hong Kong currency price of 1 unit of Singaporean
currency.
Assume that 𝐹𝑆\𝑈 is governed by the following dynamics (GBM) under the risk
neutral measure 𝑄𝑆 in the Singaporean currency world: 𝑑𝐹𝑆\𝑈
𝐹𝑆\𝑈= (𝑟𝑆𝐺𝐷 − 𝑟𝑈𝑆𝐷)𝑑𝑡 + 𝜎𝐹𝑆\𝑈𝑑𝑍𝐹𝑆\𝑈
𝑄𝑆 ,
where 𝑍𝐹𝑆\𝑈𝑄𝑆 is the Brownian motion under 𝑄𝑆.
We consider a quanto option that pays 𝐹𝐻\𝑆 Hong Kong dollars if 𝐹𝑆\𝑈 is above the
strike price 𝑋. Find the value of the quanto option in Hong Kong currency in terms of
the riskless interest rates of different currency worlds and volatility values 𝜎𝐹𝑆\𝑈 and
𝜎𝐹𝐻\𝑆 .
Solution
We shall calculate the price of the quanto options by the following steps:
Using risk neutral valuation principle, the price of the quanto price (in HKD currency) is
given by
𝑉𝑡 = 𝑒−𝑟𝐻𝐾𝐷(𝑇−𝑡)𝔼𝑄
𝐻[𝑉𝑇|ℱ𝑡] = 𝑒
−𝑟𝐻𝐾𝐷(𝑇−𝑡)𝔼𝑄𝐻[𝐹𝐻\𝑆(𝑇)𝟏{𝐹𝑆\𝑈(𝑇)>𝑋}|ℱ𝑡].
Since the expectation involves two random variables, one needs to simplify the
expectation by applying “change of numeraire” technique.
Note that 𝐹𝐻\𝑆 represents the price of 1 unit of Singaporean currency in HKD currency.
We shall choose Singaporean currency as our new numeraire.
We take 𝑁𝑡 = 𝑒𝑟𝑆𝐺𝐷𝑡𝐹𝐻\𝑆(𝑡) as the numeriare. By numeraire invariance theorem, the
pricing formula can be expressed as
𝑉𝑡 = 𝑒−𝑟𝐻𝐾𝐷(𝑇−𝑡)𝔼𝑄
𝐻[𝐹𝐻\𝑆(𝑇)𝟏{𝐹𝑆\𝑈(𝑇)>𝑋}|ℱ𝑡]
=⏞𝑀𝑡=𝑒
𝑟𝐻𝐾𝐷𝑡𝑀𝑡𝑀𝑇
𝔼𝑄𝐻[𝐹𝐻\𝑆(𝑇)𝟏{𝐹𝑆\𝑈(𝑇)>𝑋}|ℱ𝑡]
= 𝑀𝑡𝔼𝑄𝐻 [
𝐹𝐻\𝑆(𝑇)
𝑀𝑇𝟏{𝐹𝑆\𝑈(𝑇)>𝑋}|ℱ𝑡] = 𝑁𝑡𝔼
𝑄𝑆 [𝐹𝐻\𝑆(𝑇)
𝑁𝑇𝟏{𝐹𝑆\𝑈(𝑇)>𝑋}|ℱ𝑡]
= 𝑒𝑟𝑆𝐺𝐷𝑡𝐹𝐻\𝑆(𝑡)𝔼𝑄𝑆 [
𝐹𝐻\𝑆(𝑇)
𝑒𝑟𝑆𝐺𝐷𝑇𝐹𝐻\𝑆(𝑇)𝟏{𝐹𝑆\𝑈(𝑇)>𝑋}|ℱ𝑡]
= 𝑒−𝑟𝑆𝐺𝐷(𝑇−𝑡)𝐹𝐻\𝑆(𝑡)𝔼𝑄𝑆 [𝟏{𝐹𝑆\𝑈(𝑇)>𝑋}|ℱ𝑡]
Step 1: Choose the “correct” measure (HKD/SGD/USD) for calculating the price
12 MAFS5030 Quantitative Modeling of Derivative Securities
Tutorial Note 4
So we get
Recall that 𝐹𝑆\𝑈 denotes the price of 1 unit of US currency in Singaporean currency and
it can be treated as price of an asset in Singaporean currency. Under risk neutral
probability measure 𝑄𝑆, 𝐹𝑆\𝑈 should follow (as given in the question):
(*Note: Here, 𝑟𝑈𝑆𝐷 is seen to be continuous yield rate (risk-free interest of USD
currency) of the underlying asset (USD currency).)
Given the current exchange rate 𝐹𝑆\𝑈 = 𝐹𝑆\𝑈(𝑡) at time 𝑡, the exchange rate at the
maturity date 𝑇 can be expressed as
Here, 𝑍𝐹𝑆\𝑈𝑄𝑆 = 𝑍𝐹𝑆\𝑈,𝑇−𝑡
𝑄𝑆 is normally distributed with mean 0 and variance 𝑇 − 𝑡 under
𝑄𝑆.
Note that
𝐹𝑆\𝑈(𝑇) > 𝑋 ⇔ 𝑍𝐹𝑆\𝑈𝑄𝑆 >
ln𝑋𝐹𝑆\𝑈
− (𝑟𝑆𝐺𝐷 − 𝑟𝑈𝑆𝐷 −𝜎𝐹𝑆\𝑈2
2 ) (𝑇 − 𝑡)
𝜎𝐹𝑆\𝑈⏟ 𝑑
Then the expectation can be computed as
𝔼𝑄𝑆[𝟏{𝐹𝑆\𝑈(𝑇)>𝑋}|ℱ𝑡] = ∫ (1) (
1
√2𝜋(𝑇 − 𝑡)𝑒−
𝑧2
2(𝑇−𝑡))𝑑𝑧∞
𝑑
=⏞
𝑦=𝑧
√𝑇−𝑡
∫1
√2𝜋𝑒−
𝑦2
2 𝑑𝑦∞
𝑑
√𝑇−𝑡
= 1 − 𝑁 (𝑑
√𝑇 − 𝑡) = 𝑁 (−
𝑑
√𝑇 − 𝑡)
𝑉𝑡 = 𝑒−𝑟𝑆𝐺𝐷(𝑇−𝑡)𝐹𝐻\𝑆(𝑡)𝔼
𝑄𝑆 [𝟏{𝐹𝑆\𝑈(𝑇)>𝑋}|ℱ𝑡]
Step 2: Predict the price dynamic of 𝐹𝑆\𝑈
𝑑𝐹𝑆\𝑈
𝐹𝑆\𝑈= (𝑟𝑆𝐺𝐷 − 𝑟𝑈𝑆𝐷)𝑑𝑡 + 𝜎𝐹𝑆\𝑈𝑑𝑍𝐹𝑆\𝑈
𝑄𝑆 .
Step 3: Compute the price of the options
𝐹𝑆\𝑈(𝑇) = 𝐹𝑆\𝑈𝑒(𝑟𝑆𝐺𝐷−𝑟𝑈𝑆𝐷−
𝜎𝐹𝑆\𝑈2
2)(𝑇−𝑡)+𝜎𝐹𝑆\𝑈𝑍𝐹𝑆\𝑈
𝑄𝑆
.
13 MAFS5030 Quantitative Modeling of Derivative Securities
Tutorial Note 4
= 𝑁
(
ln𝐹𝑆\𝑈𝑋 + (𝑟𝑆𝐺𝐷 − 𝑟𝑈𝑆𝐷 −
𝜎𝐹𝑆\𝑈2
2 ) (𝑇 − 𝑡)
𝜎𝐹𝑆\𝑈√𝑇 − 𝑡⏟ =𝑑1 )
.
Then the current price of the derivative is given by
𝑉𝑡 = 𝑒−𝑟𝑆𝐺𝐷(𝑇−𝑡)𝐹𝐻\𝑆(𝑡)𝑁(𝑑1).
Example 5 (Problem 9 of HW3)
We let 𝐹𝑆\𝑈 denote the Singaporean currency price of one unit of US currency and
𝐹𝐻\𝑆 denote the Hong Kong currency price of one unit of Singaporean currency.
Suppose we assume 𝐹𝑆\𝑈 to be governed by the following dynamics under the risk
neutral measure 𝑄𝑆 in the Singaporean currency world: 𝑑𝐹𝑆\𝑈
𝐹𝑆\𝑈= (𝑟𝑆𝐺𝐷 − 𝑟𝑈𝑆𝐷)𝑑𝑡 + 𝜎𝐹𝑆\𝑈𝑑𝑍𝐹𝑆\𝑈
𝑄𝑆 ,
Where 𝑟𝑆𝐺𝐷 and 𝑟𝑈𝑆𝐷 are the Singaporean and US riskless interest rates, respectively.
Similar Geometric Brownian motion assumption is made of other exchange rate
processes.
We consider a digital quanto option pays 1 US dollar at maturity if 𝐹𝑆\𝑈 is above
𝛼𝐹𝐻\𝑈 for some constant value 𝛼. Find the value of the digital quanto option in Hong
Kong currency.
Solution
We shall calculate the price of the quanto options by the following steps:
Using risk neutral valuation principle, the price of the quanto price (in HKD currency) is
given by
𝑉𝑡 = 𝑒−𝑟𝐻𝐾𝐷(𝑇−𝑡)𝔼𝑄
𝐻[𝑉𝑇|ℱ𝑡] = 𝑒
−𝑟𝐻𝐾𝐷(𝑇−𝑡)𝔼𝑄𝐻[𝐹𝐻\𝑈(𝑇)𝟏{𝐹𝑆\𝑈(𝑇)>𝛼𝐹𝐻\𝑈(𝑇)}|ℱ𝑡]
= 𝑒−𝑟𝐻𝐾𝐷(𝑇−𝑡)𝔼𝑄𝐻[𝐹𝐻\𝑈(𝑇)𝟏
{𝐹𝑆\𝑈(𝑇)
𝐹𝐻\𝑈(𝑇)>𝛼}|ℱ𝑡]
=⏞
𝐹𝑈\𝐻=1
𝐹𝐻\𝑈
𝑒−𝑟𝐻𝐾𝐷(𝑇−𝑡)𝔼𝑄𝐻[𝐹𝐻\𝑈(𝑇)𝟏{𝐹𝑆\𝑈(𝑇)𝐹𝑈\𝐻(𝑇)>𝛼}|ℱ𝑡]
=⏞
𝐹𝑆\𝐻=𝐹𝑆\𝑈𝐹𝑈\𝐻
𝑒−𝑟𝐻𝐾𝐷(𝑇−𝑡)𝔼𝑄𝐻[𝐹𝐻\𝑈(𝑇)𝟏{𝐹𝑆\𝐻(𝑇)>𝛼}|ℱ𝑡].
Step 1: Choose the “correct” measure (HKD/SGD/USD) for calculating the price
14 MAFS5030 Quantitative Modeling of Derivative Securities
Tutorial Note 4
Since the expectation involves two random variables, one needs to simplify the
expectation by applying “change of numeraire” technique.
Note that 𝐹𝐻\𝑈 represents the price of 1 unit of USD currency in HKD currency. We shall
choose USD currency as our new numeraire.
We take 𝑁𝑡 = 𝑒𝑟𝑈𝑆𝐷𝑡𝐹𝐻\𝑈(𝑡) as the numeriare. By numeraire invariance theorem, the
pricing formula can be expressed as
𝑉𝑡 = 𝑒−𝑟𝐻𝐾𝐷(𝑇−𝑡)𝔼𝑄
𝐻[𝐹𝐻\𝑈(𝑇)𝟏{𝐹𝑆\𝐻(𝑇)>𝛼}|ℱ𝑡]
=⏞𝑀𝑡=𝑒
𝑟𝐻𝐾𝐷𝑡𝑀𝑡𝑀𝑇
𝔼𝑄𝐻[𝐹𝐻\𝑈(𝑇)𝟏{𝐹𝑆\𝐻(𝑇)>𝛼}|ℱ𝑡]
= 𝑀𝑡𝔼𝑄𝐻 [
𝐹𝐻\𝑈(𝑇)
𝑀𝑇𝟏{𝐹𝑆\𝐻(𝑇)>𝛼}|ℱ𝑡] = 𝑁𝑡𝔼
𝑄𝑈 [𝐹𝐻\𝑈(𝑇)
𝑁𝑇𝟏{𝐹𝑆\𝐻(𝑇)>𝛼}|ℱ𝑡]
= 𝑒𝑟𝑈𝑆𝐷𝑡𝐹𝐻\𝑈(𝑡)𝔼𝑄𝑈 [
𝐹𝐻\𝑈(𝑇)
𝑒𝑟𝑈𝑆𝐷𝑇𝐹𝐻\𝑈(𝑇)𝟏{𝐹𝑆\𝐻(𝑇)>𝛼}|ℱ𝑡]
= 𝑒−𝑟𝑈𝑆𝐷(𝑇−𝑡)𝐹𝐻\𝑈(𝑡)𝔼𝑄𝑈 [𝟏{𝐹𝑆\𝐻(𝑇)>𝛼}|ℱ𝑡]
So we get
Since 𝐹𝑆\𝐻 is assumed to follow GBM, so the governing equation for 𝐹𝑆\𝐻 is
where 𝑍𝐹𝑆\𝐻𝑄𝑈 is 𝑄𝑈-Brownian.
However, 𝐹𝑆\𝐻 denotes the price of 1 HKD currency in SGD currency (not USD currency).
So we CANNOT simply say that the drift rate 𝛿𝐹𝑆\𝐻𝑈 equals 𝑟𝑆𝐺𝐷 − 𝑟𝐻𝐾𝐷.
Here, one has to apply quanto prewashing technique to find the drift rate 𝛿𝐹𝑆\𝐻𝑈 .
By treating 𝐹𝑆\𝐻 as the foreign asset (price in SGD currency) and taking 𝐹𝑈\𝑆 as the
exchange rate (SGD → USD), we observe that the product 𝐹𝑈\𝑆𝐹𝑆\𝐻 = 𝐹𝑈\𝐻 is simply the
price of 1 HKD currency in USD currency.
So under 𝑄𝑈, the price dynamic of 𝐹𝑈\𝐻 should satisfy
𝑑𝐹𝑈\𝐻
𝐹𝑈\𝐻= (𝑟𝑈𝑆𝐷 − 𝑟𝐻𝐾𝐷)⏟
𝑑𝑟𝑖𝑓𝑡 𝑟𝑎𝑡𝑒
𝑑𝑡 + 𝜎𝐹𝑈\𝐻𝑑𝑍𝐹𝑈\𝐻𝑄𝑈 ……(2).
𝑉𝑡 = 𝑒−𝑟𝑈𝑆𝐷(𝑇−𝑡)𝐹𝐻\𝑈(𝑡)𝔼
𝑄𝑈 [𝟏{𝐹𝑆\𝐻(𝑇)>𝛼}|ℱ𝑡].
Step 2: Predict the price dynamic of 𝐹𝑆\𝐻 in 𝑄𝑈
𝑑𝐹𝑆\𝐻
𝐹𝑆\𝐻= 𝛿𝐹𝑆\𝐻
𝑈 𝑑𝑡 + 𝜎𝐹𝑆\𝐻𝑑𝑍𝐹𝑆\𝐻𝑄𝑈 , …… (1)
.
15 MAFS5030 Quantitative Modeling of Derivative Securities
Tutorial Note 4
On the other hand, the price dynamic of 𝐹𝑈\𝑆 under 𝑄𝑈 is given by
𝑑𝐹𝑈\𝑆
𝐹𝑈\𝑆= (𝑟𝑈𝑆𝐷 − 𝑟𝑆𝐺𝐷)⏟
𝑑𝑟𝑖𝑓𝑡 𝑟𝑎𝑡𝑒
𝑑𝑡 + 𝜎𝐹𝑈\𝑆𝑑𝑍𝐹𝑈\𝑆𝑄𝑈 ……(3).
applying Ito’s lemma on 𝑓 = 𝐹𝑈\𝑆𝐹𝑆\𝐻, we get (*Note: We assume 𝑑𝑍𝐹𝑈\𝑆𝑄𝑈 𝑑𝑍𝐹𝑆\𝐻
𝑄𝑈 = 𝜌𝑑𝑡)
𝑑(𝐹𝑈\𝑆𝐹𝑆\𝐻)
𝐹𝑈\𝑆𝐹𝑆\𝐻⏟
=𝑑𝐹𝑈\𝐻𝐹𝑈\𝐻
= [(𝑟𝑈𝑆𝐷 − 𝑟𝑆𝐺𝐷) + 𝛿𝐹𝑆\𝐻𝑈 + 𝜌𝜎𝐹𝑈\𝑆𝜎𝐹𝑆\𝐻] 𝑑𝑡 + 𝜎𝐹𝑈\𝑆𝑑𝑍𝐹𝑈\𝑆
𝑄𝑈 + 𝜎𝐹𝑆\𝐻𝑑𝑍𝐹𝑆\𝐻𝑄𝑈 .
By comparing the drift rates [with equation (2)], we have
(𝑟𝑈𝑆𝐷 − 𝑟𝑆𝐺𝐷) + 𝛿𝐹𝑆\𝐻𝑈 + 𝜌𝜎𝐹𝑈\𝑆𝜎𝐹𝑆\𝐻 = 𝑟𝑈𝑆𝐷 − 𝑟𝐻𝐾𝐷
Given the current value of 𝐹𝑆\𝐻 = 𝐹𝑆\𝐻(𝑡), the exchange rate at the maturity date can
be expressed as (from equation (1)):
𝐹𝑆\𝐻(𝑇) = 𝐹𝑆\𝐻𝑒(𝛿𝐹𝑆\𝐻
𝑈 −𝜎𝐹𝑆\𝐻2
2)(𝑇−𝑡)+𝜎𝐹𝑆\𝐻𝑍𝐹𝑆\𝐻
𝑄𝑈
,
where 𝑍𝐹𝑆\𝐻𝑄𝑈 = 𝑍𝐹𝑆\𝐻
𝑄𝑈 (𝑇 − 𝑡) is normally distributed with mean 0 and variance 𝑇 − 𝑡
under 𝑄𝐶. Note that
𝐹𝑆\𝐻(𝑇) > 𝛼 ⇔ 𝑍𝐹𝑆\𝐻𝑄𝑈
>
ln𝛼𝐹𝑆\𝐻
− (𝛿𝐹𝑆\𝐻𝑈 −
𝜎𝐹𝑆\𝐻2
2 ) (𝑇 − 𝑡)
𝜎𝐹𝑆\𝐻⏟ 𝑑
So the expectation (in step 1) can be computed as
𝔼𝑄𝑈[𝟏{𝐹𝑆\𝐻(𝑇)>𝛼}|ℱ𝑡] = ∫ (1) (
1
√2𝜋(𝑇 − 𝑡)𝑒−
𝑧2
2(𝑇−𝑡))𝑑𝑧∞
𝑑
=⏞
𝑦=𝑧
√𝑇−𝑡
∫1
√2𝜋𝑒−
𝑦2
2 𝑑𝑦∞
𝑑
√𝑇−𝑡
= 1 − 𝑁 (𝑑
√𝑇 − 𝑡) = 𝑁 (−
𝑑
√𝑇 − 𝑡)
= 𝑁
(
ln𝐹𝑆\𝐻𝛼+ (𝛿𝐹𝑆\𝐻
𝑈 −𝜎𝐹𝑆\𝐻2
2) (𝑇 − 𝑡)
𝜎𝐹𝑆\𝐻√𝑇 − 𝑡⏟ =𝑑1 )
.
Then the current price of the derivative is given by
𝑉𝑡 = 𝑒−𝑟𝑈𝑆𝐷(𝑇−𝑡)𝐹𝐻\𝑈(𝑡)𝑁(𝑑1),
where 𝛿𝐹𝑆\𝐻𝑈 = 𝑟𝑆𝐺𝐷 − 𝑟𝐻𝐾𝐷 − 𝜌𝜎𝐹𝑈\𝑆𝜎𝐹𝑆\𝐻 .
⇒ 𝛿𝐹𝑆\𝐻𝑈 = 𝑟𝑆𝐺𝐷 − 𝑟𝐻𝐾𝐷 − 𝜌𝜎𝐹𝑈\𝑆𝜎𝐹𝑆\𝐻
Step 3: Compute the price of the options
16 MAFS5030 Quantitative Modeling of Derivative Securities
Tutorial Note 4
Appendix – Some useful theorem
Girsanov Theorem
Let 𝑍𝑃(𝑡) be a Brownian motion under the probability measure 𝑃. Consider a non-
anticipative function 𝛾(𝑡) with respect to 𝑍𝑃(𝑡) that satisfies the Novikov condition:
𝔼 [𝑒∫12𝛾(𝑠)2𝑑𝑠
𝑡0 ] < ∞
We let �̃� be another probability measure and consider the Radon-Nikodym derivative
𝑑�̃�
𝑑𝑃= 𝜌(𝑡) = exp(∫ −𝛾(𝑠)𝑑𝑍𝑝(𝑠)
𝑡
0
−1
2∫ 𝛾(𝑠)2𝑑𝑠𝑡
0
).
Then under the new probability measure �̃�, the stochastic process
𝑍�̃�(𝑡) = 𝑍𝑃(𝑡) + ∫ 𝛾(𝑠)𝑑𝑠𝑡
0
.
is a Brownian motion under �̃�.
Remark
Suppose that a stochastic process 𝑆𝑡 satisfies
𝑑𝑆𝑡 = 𝑎(𝑡, 𝑆𝑡)𝑑𝑡 + 𝑏(𝑡, 𝑆𝑡)𝑑𝑍𝑡𝑃,
where 𝑍𝑡𝑃 is the Brownian motion under 𝑃.
Suppose that the probability measure 𝑃 is changed to �̃�, then the dynamics of the
process 𝑆𝑡 becomes
𝑑𝑆𝑡 = 𝑎(𝑡, 𝑆𝑡)𝑑𝑡 + 𝑏(𝑡, 𝑆𝑡)𝑑 (𝑍𝑡�̃� −∫ 𝛾(𝑠)𝑑𝑠
𝑡
0
) = 𝑎(𝑡, 𝑆𝑡)𝑑𝑡 + 𝑏(𝑡, 𝑆𝑡)[𝑑𝑍𝑡�̃� − 𝛾(𝑡)𝑑𝑡]
⇒ 𝑑𝑆𝑡 = [𝑎(𝑡, 𝑆𝑡) − 𝛾(𝑡)𝑏(𝑡, 𝑆𝑡)]𝑑𝑡 + 𝑏(𝑡, 𝑆𝑡)𝑑𝑍𝑡�̃�.
(*Note: Remember that 𝛾(𝑡) is non-anticipative and the value is fixed up to time 𝑡).
Numeraire Invariance Theorem
Let 𝑁(𝑡) be a numeraire and assume that there is an equivalent probability measure 𝑄𝑁
such that
𝔼𝑄𝑁 [𝑆(𝑇)
𝑁(𝑇)|ℱ𝑡] =
𝑆(𝑡)
𝑁(𝑡).
Here, 𝑆(𝑡) is the price of an asset. Suppose that a contingent claim 𝑌 is attainable, then
we have
𝑀(𝑡)𝔼𝑄 [𝑌
𝑀(𝑇)|ℱ𝑡] = 𝑁(𝑡)𝔼
𝑄𝑁 [𝑌
𝑁(𝑇)|ℱ𝑡].
Here, 𝑄 is risk neutral probability measure and 𝑀(𝑡) = 𝑒𝑟𝑡 is the money market
account.