Pricing and hedging performance on pegged FX markets based on a regime switching model

Abstract

This paper investigates the hedging performance of a pegged foreign exchange market in a regime switching (RS) model introduced by Drapeau et al. We compare two prices, an exact solution and first-order approximation and provide bounds for the error. We provide exact RS delta, approximate RS delta as well as mean variance hedging strategies for this specific model and compare their performance. To improve the efficiency of the pricing and calibration procedure, a Fourier approach to this regime-switching model is developed in our work. It turns out that: (1) the calibration of the volatility surface with this regime switching model outperforms the classical SABR model on real data; (2) the Fourier approach is significantly faster than the direct approach; (3) in terms of hedging, the approximate RS delta hedge is a viable alternative to the exact RS delta hedge while significantly faster.