PRICING and STATIC REPLICATION of FX
QUANTO OPTIONS
Fabio Mercurio
Financial Models, Banca IMI
1 Introduction
1.1 Notation
t: the evaluation time.
τ : the running time.
Sτ : the price at time τ in domestic currency of one unit of foreign currency.
rτd : the (deterministic) domestic instantaneous risk-free rate at time τ .
rτf : the (deterministic) foreign instantaneous risk-free rate at time τ .
στ : the exchange rate (deterministic) percentage volatility at time τ .
X: a strike price.
ω: a flag for call (ω = 1) or put (ω = −1).
T, T1 , T2 : future times.
Qd : the domestic risk-neutral measure.
E d : expectation under Qd .
QN : the probability measure associated with the numeraire N .
E N : expectation under QN .
Fτ : the σ-algebra generated by S up to time τ .
1A : the indicator function of the set A.
C(t, T, X): price at time t of a (plain-vanilla) call option with maturity T and strike X.
P(t, T, X): price at time t of a (plain-vanilla) put option with maturity T and strike X.
AoNC(t, T, X): price at time t of an asset-or-nothing call with maturity T and strike X.
AoNP(t, T, X): price at time t of an asset-or-nothing put with maturity T and strike X.
QO(t, T, X, ω): price at time t of a quanto option with maturity T and strike X.
FSQO(t, T1 , T2 , ω): price at time t of a forward-start quanto option with forward-start date T1 and maturity
T2 .
QCqt(t, T1 , T2 , ω): price at time t of a quanto cliquet option with forward-start date T1 and maturity T2 .
1.2 Assumptions
The exchange rate S is assumed to evolve under the domestic risk-neutral measure Qd
according to:
dSτ = Sτ [(rτd − rτf ) dτ + στ dWτ ]
1
FX quanto options
¡Rτ ¢
where W is a standard Brownian motion under Qd . Setting S̄τ = Sτ exp 0
ruf du , the
dynamics of S under the measure QS̄ having S̄ as numeraire is
dSτ = Sτ [(rτd − rτf + στ2 ) dτ + στ dW̄τ ] (1)
where W̄ is a standard Brownian motion under QS̄ .
1.3 Pricing
The no-arbitrage price at time t of the payoff HT at time T is
RT d du
Ht = e − t ru
E d [HT |Ft ]
Using S̄ as numeraire, the time t-price becomes
· ¸
S̄ HT
Ht = S̄t E |Ft
S̄T
RT
· ¸ (2)
− f
ru du S̄ HT
= St e t E |Ft
ST
2 Quanto Options
Pricing of a Quanto Option
A quanto option pays out at maturity T the amount [ω(ST − X)]+ in foreign currency,
which is equivalent to [ω(ST − X)]+ ST in domestic currency:
[ω(ST − X)]+ ST
-
t T
To price the payoff HT = [ω(ST − X)]+ ST it is convenient to use formula (2). In fact
RT f
QO(t, T, X, ω) = St e− t ru du
E S̄ [(ωST − ωX)+ |Ft ]
This expectation can be easily calculated under (1), since it is equivalent to an non-
discounted Black-Scholes price for an underlying asset paying a continuous dividend yield
qτ = rτf − στ2 . We thus obtain:
R h RT d f i
− tT ru
f
du 2 ) du
(ru −ru +σu
QO(t, T, X, ω) = ωSt e St e t Φ(ωd0 ) − XΦ(ωd1 )
R T
ln SXt + t (rud − ruf + 32 σu2 ) du
d0 = qR
T 2
σu du (3)
t
s
Z T
d1 = d0 − σu2 du
t
2
FX quanto options
Static Replication of a Quanto Option
In the call option case, we have
Z +∞ Z +∞
+
(ST − X) ST = ST 1{ST >K} dK = 2 (ST − K)+ dK + X(ST − X)+ (4)
X X
Therefore, a quanto call can be statically replicated by means of asset-or-nothing calls or,
equivalently, plain-vanilla calls as follows:
Z +∞ Z +∞
QO(T, T, X, 1) = AoNC(T, T, K) dK = 2 C(T, T, K) dK + XC(T, T, X)
X X
In the put option case, we have instead
Z X Z X
+ +
(X − ST ) ST = ST 1{K>ST } dK = X(X − ST ) − 2 (K − ST )+ dK
0 0
Therefore, a quanto put can be statically replicated by means of asset-or-nothing puts or,
equivalently, plain-vanilla puts as follows:
Z X Z X
QO(T, T, X, −1) = AoNP(T, T, K) dK = XP(T, T, X) − 2 P(T, T, K) dK
0 0
3 Forward-Start Quanto Options
Pricing of a Forward-Start Quanto Option
A forward-start quanto option pays out at maturity T2 > T1 the amount [ω(ST2 − ST1 )]+
in foreign currency, which is equivalent to [ω(ST2 − ST1 )]+ ST2 in domestic currency:
[ω(ST2 − ST1 )]+ ST2
-
t T1 T2
Since we can write
R T1 d du
FSQO(t, T1 , T2 , ω) = e− t ru
E d [QO(T1 , T2 , ST1 , ω)|Ft ]
using formula (3) and calculating the (risk-neutral) second moment of ST1 conditional on
3
FX quanto options
Ft , we obtain
R T1 d f 2
R T2 f
h R T2 d f 2 i
FSQO(t, T1 , T2 , ω) = ωSt2 e t (ru −ru +σu ) du− t ru du
e T1 (ru −ru +σu ) du Φ(ωd0 ) − Φ(ωd1 )
R T2 d
(ru − ruf + 32 σu2 ) du
d0 = T1 qR
T2 2
T1
σu du
sZ
T2
d1 = d0 − σu2 du
T1
(5)
Static Replication of a Forward-Start Quanto Option
The static replication of the value at time T1 of a forward-start quanto option boils down
to the static replication of ST21 , both in the call and put cases. We then use (4), with X = 0
and T = T1 , thus obtaining
Z +∞ Z +∞
2
ST1 = ST1 1{ST1 >K} dK = 2 (ST1 − K)+ dK
0 0
Therefore, the squared exchange rate can be statically replicated by means of asset-or-
nothing calls or, equivalently, plain-vanilla calls as follows:
Z +∞ Z +∞
ST21 = AoNC(T1 , T1 , K) dK = 2 C(T1 , T1 , K) dK
0 0
Remark 3.1. If the evaluation time t lies, instead, in the interval (T1 , T2 ), a forward-start
quanto option is equivalent to a quanto option with a given strike (the previously set ST1 ).
We then refer to the previous section for its pricing and replication.
4 Quanto Cliquets
Pricing of a Quanto Cliquet
A quanto cliquet option pays out at maturity T2 > T1 the amount [ω(ST2 − ST1 )/ST1 ]+ in
foreign currency, which is equivalent to [ω(ST2 − ST1 )/ST1 ]+ ST2 in domestic currency:
ST2 −ST1 +
[ω ST1
] ST2
-
t T1 T2
4
FX quanto options
Since the time T2 -payoff of a quanto cliquet is equal to that of the corresponding forward-
start quanto option divided by ST1 , the same applies to the corresponding values at time
T1 :
FSQO(T1 , T1 , T2 , ω)
QCqt(T1 , T1 , T2 , ω) =
ST1
By (5), the calculation of the time t-price boils down to the calculation of the (risk-neutral)
expectation of ST1 conditional on Ft . We obtain
R T2 f
h R T2 d f 2 i
− ru du T1 (ru −ru +σu ) du
QCqt(t, T1 , T2 , ω) = ωSt e t e Φ(ωd0 ) − Φ(ωd1 )
R T2 d
(ru − ruf + 32 σu2 ) du
d0 = T1 qR
T2 2
σu du (6)
T1
sZ
T2
d1 = d0 − σu2 du
T1
Static Replication of a Quanto Cliquet
The quanto cliquet value at time T1 is linear in ST1 . A static replication is then achieved
by buying a proper amount of foreign currency S.
Remark 4.1. If the evaluation time t lies, instead, in the interval (T1 , T2 ), a quanto cliquet
is equivalent to a constant by a quanto option with a given strike, where the inverse of the
constant and the strike are equal to the known value of ST1 . We then refer to the related
section for its pricing and replication.