Constructing Volatility Surfaces for Cross FX Rates1. (August 2016)

• Record Type: Journal Article
• Authors: Yoon, Jungyeon
• Is Part Of: Asia-Pacific journal of financial studies. Volume 45:Number 4(2016:Aug.)
• Page Start: 646
• Page End: 665
• Publication Date: 2016-08
• Subjects: Cross FX options -- Stochastic volatility -- Stochastic skew -- Volatility surface -- Multifactor model; Pacific Area -- Economic conditions -- Periodicals; Finance -- Asia -- Periodicals; Finance -- Pacific Area -- Periodicals; Asia -- Economic conditions -- Periodicals; 332.09505
• DOI: 10.1111/ajfs.12140
• Languages: English
• ISSNs: 2041-9945

Abstract

Abstract: This paper examines the multi‐factor stochastic volatility model for pricing options on a cross foreign exchange (FX) rate. Given the behavior of FX implied volatilities, the lack of liquidity makes it challenging to construct a volatility surface of the cross FX rate for the purpose of pricing out‐of‐the‐money options with different maturities and various structured products. The proposed joint model consistently reproduces the volatility smile and skew for each FX rate and stochastic correlations among FX rates, while preserving the triangular relationship of FX implied volatilities. The empirical results indicate that the joint model outperforms the traditional benchmark stochastic volatility models estimated only with at‐the‐money options on the cross FX rate both in‐sample and out‐of‐sample.