Pricing currency derivatives under the benchmark approach

Abstract

This paper considers the realistic modelling of derivative contracts on exchange rates. We propose a stochastic volatility model that recovers not only the typically observed implied volatility smiles and skews for short dated vanilla foreign exchange options but allows one also to price payoffs in foreign currencies, lower than possible under classical risk neutral pricing, in particular, for long dated derivatives. The main reason for this important feature is the strict supermartingale property of benchmarked savings accounts under the real world probability measure, which the calibrated parameters identify under the proposed model. Using a real dataset on vanilla option quotes, we calibrate our model on a triangle of currencies and find that the risk neutral approach fails for the calibrated model, while the benchmark approach still works.