Skip to content
All library documents

Modeling FX Option Prices Across Exchange Rate Regime Changes

Article Quant Q&A · Author: SquaredCircle
Read the original

Summary

This discussion considers how a shift from a currency peg toward a freer float could affect over-the-counter FX option prices, using the Moroccan dirham’s EUR and USD relationships as context. It notes that a regime change may bring a spot jump together with a volatility jump, and points to a stochastic volatility and jump model as one way to represent both effects.

Because such a model may require many parameters relative to the available market data, the response suggests Merton jump diffusion as a more tractable alternative. That model includes jumps in spot but not volatility, and the post describes calibrating its smaller parameter set to vanilla option quotes, potentially fixing the jump arrival rate. These are modeling suggestions rather than a calibrated estimate: the discussion provides no market quotes, parameter values, or predicted price changes, and emphasizes the limited data available for the case.

Key ideas

  • An exchange rate regime change may affect options through jumps in spot and volatility.
  • A stochastic volatility and jump model can represent both types of discontinuity.
  • Merton jump diffusion offers a simpler model focused on spot jumps.
  • Model complexity and sparse market data can limit reliable calibration.

Tags

ForexOptionsVolatilityDerivatives pricing
Full text
# FX options pricing exchange rate regimes


# FX options pricing exchange rate regimes












how can we estimate the impact of a exchange rate regime switch ( from fixed to float) on the options prices i'm talking about the moroccan case (EUR/MAD USD/MAD) options OTC , is there any stochastic model for this ? thanks in advance

## Answer by q.t.f. (score 1)

https://quant.stackexchange.com/a/32771

MAD has been pegged to a basket of EUR and USD. Recently the weight of EUR in the basket has been decreased in favor of USD, and there is discussion of making the exchange rate float more freely still.

A regime change often involves a jump of the spot exchange rate simultaneously to a jump in the volatility. There are some such models even with analytic tractability : see the Duffie, Pan, & Singleton SVJ-Y-V model [1] for instance. Estimating or calibrating such a complicated model for MAD may be unrealistic however. There are lots of parameters and not so much good data to estimate from.

A simpler model that might do well is the Merton jump diffusion [2]. That has only jumps in spot, not vol, but the impact of spot jumps is bigger on vanillas anyway. And that model is only 4 parameters to estimate, something you might calibrate to some vanilla quotes maybe with a fixed guess for the jump arrival rate.

[1] http://pages.stern.nyu.edu/~dbackus/Disasters/DuffiePanSingleton%20jumps%20Econometrica%2000.PDF

[2] http://www.qfrc.uts.edu.au/research/research_papers/rp287.pdf

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

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