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

T.K. Siu, H. Yang, John Lau

    Research output: Contribution to journalArticle

    41 Citations (Scopus)

    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. (C) 2008 Elsevier B.V. All rights reserved.
    Original languageEnglish
    Pages (from-to)295-302
    JournalInsurance : Mathematics & Economics
    Volume43
    DOIs
    Publication statusPublished - 2008

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