Calibrating Local Volatility Models to FX Skew for Exotic Options

Summary

This paper addresses pricing American and Asian options in foreign-exchange derivatives markets, where banks use complex models and different model choices can produce inconsistent prices for the same exotic contract. The authors study a fully parameterized local-volatility model intended to price these products while matching observed FX volatility skew. The calibration can be implemented with either a numerical grid or Monte Carlo methods, and the abstract describes it as both efficient and accurate.

The proposed application is daily pricing of exotic options, with the aim of producing more consistent values for risk management. The document does not provide calibration errors, market data details, model assumptions, or comparisons against specific alternatives. Its claims therefore describe the model’s intended capability, but the abstract alone does not establish how well it performs across currencies, market regimes, or particular option structures.

Key ideas

• The study targets American and Asian FX options, whose prices can vary across models.
• It evaluates a fully parameterized local-volatility model calibrated to market skew.
• Calibration can use grid-based or Monte Carlo numerical methods.
• The intended use is consistent daily pricing of exotic FX options.
• The abstract offers no quantitative error measures or details on model validation across markets.

Tags

# Efficient and Accurate Calibration to FX Market Skew with Fully Parameterized Local Volatility Model


# Efficient and Accurate Calibration to FX Market Skew with Fully Parameterized Local Volatility Model









When trading American and Asian options in the FX derivatives market, banks must calculate prices using a complex mathematical model. It is often observed that different models produce varying prices for the same exotic option, which violates the non-arbitrage requirement of derivative risk management. To address this issue, we have studied a fully parameterized local volatility model for pricing American/Asian options. This model, when implemented using a grid or Monte-Carlo numerical method, can be efficiently and accurately calibrated to FX market skew volatilities. As a result, the model can provide reliable prices for exotic options during daily trading activities.

Shown in full with attribution under the source's licence. Licence: abstract CC0

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.