The efficient pricing and hedging of vanilla and exotic foreign exchange options requires an adequate model that takes into account both the local and the stochastic features of the volatility dynamics. In this joint work, we put forward a four-factor hybrid local-stochastic volatility (LSV) model that combines state-of-the-art dynamics for the exchange rate with stochastic dynamics for the domestic and foreign short rates, and provide a consistent and self-contained calibration and pricing framework.
For the calibration, we propose a novel and generic algorithm that builds on the particle method of Guyon and Labordere. We combine it with new variance reduction techniques to accelerate convergence and use control variates derived from a pure local volatility model, the stochastic short rates and the two-factor Heston-type LSV model. Our numerical experiments show a dramatic variance reduction that allows us to calibrate the four-factor model at almost no extra computational cost. The method can be applied to a large class of hybrid LSV models and is not restricted to our particular choice of the diffusion.
For the pricing, we propose a Monte Carlo simulation scheme that combines the full truncation Euler (FTE) scheme for the stochastic volatility and the stochastic short rates with the log-Euler scheme for the exchange rate. We find a lower bound on the explosion time of exponential moments of FTE approximations, and prove the strong convergence of the exchange rate approximations and the convergence of Monte Carlo estimators for a number of vanilla and exotic options. We then carry out numerical experiments to justify our choice of model and demonstrate convergence.
- Mathematical Finance Internal Seminar