Abstract
In this study, we investigate the valuation of foreign exchange (FX) options by identifying a two-factor Markov-modulated stochastic volatility model with double exponential jumps to capture long- and short-term stochastic volatility and asymmetrical jumps in the underlying spot FX rate. Furthermore, the dynamics of domestic/foreign instantaneous forward interest rates are governed by a Markov-modulated Heath-Jarrow-Morton model. The dynamic measure change technique is employed to determine a pricing kernel for deriving the FX option pricing formula. Finally, numerical illustrations are provided and analyzed.
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