Fx Options And Smile Risk

Author : Kurt Smith
Publisher :
ISBN 13 :
Total Pages : 282 pages
Book Rating : 4.:/5 (93 download)

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Download or read book American Binary FX Options written by Kurt Smith and published by . This book was released on 2010 with total page 282 pages. Available in PDF, EPUB and Kindle. Book excerpt: [Truncated abstract] There is no universally accepted benchmark model for pricing exotic FX options to market, such as that for European vanilla FX options. The use of not only different models but also of different methodologies, results in widely dispersed model-dependent exotic option prices for any given set of market and contract inputs. The severity of the resultant model price dispersion is strong evidence of model risk. Model risk is especially acute for price-makers in sell-side banks who, owing to the heterogeneity of over-the-counter (OTC) exotic options, do not have actual traded daily closing mark-to-market prices for all exotic options in their book, and so must mark-to-model instead. If the model does not perform well, it will not reflect market reality, and neither will the reported daily profit and loss. Given that sell-side banks use models throughout the price-making process, from pricing market risk to identifying hedging strategies, defining risk limits, reporting to key stakeholders internally and externally, as well as determining trader bonuses and Basel II capital retention levels, model risk is an important consideration in the OTC exotic option space. The orthodox response to model risk is price centric. Orthodoxy develops models that rely on complex and esoteric mathematics in order to improve pricing accuracy, even if it results in models that are opaque and inaccessible to most price-makers and risk managers who use them. In contrast, this research focuses on hedging strategies. This is because price-makers, irrespective of the model used to price, hedge unwanted imbalances in exotic FX option risk with liquid, traded European vanilla FX option strategies like butterflies and risk reversals. Since price-maker hedging activity is relatively model-independent, whereas price is highly model-dependent, it follows that the actual hedging behaviour of price-makers should dictate the form of the pricing model if model risk is to be minimised. In this context, the traded vanilla volatility surface is only relevant to exotic option prices insofar as it prices the cost of a traded hedge. Since it is not possible, let alone practical to trade a whole-of-volatility-surface hedge, there is no economic substance to bind orthodoxy s whole-of-volatility-surface calibrations to traded exotic option prices. This research presents a variant of the vanna-volga model which, in addition to pricing smile risk and skew risk, also prices term risk, which is the risk that an exotic option terminates prior to expiry owing to the spot price trading at or through a barrier price. The model presented here uniquely prices to market the cost of a European vanilla FX option hedge portfolio that matures at the exotic FX option s expected stopping time, instead of at the expiration date like other vanna-volga models. By expiring at the exotic option s expected stopping time, the hedge uniquely prices the non-trivial term structure that is present not only in the level of volatility, but also in its smile and skew. Why price the cost of expensive long-dated butterflies if the exotic option is expected to terminate sooner, leaving a residual butterfly open position that has to be unwound...