Valuation of Long‐Maturity KIKO Options Under the Stochastic Volatility Model

Abstract

AbstractThis paper explores the valuation of KIKO currency options under the stochastic volatility (SV) model. In particular, Heston's (Review of Financial Studies, 6, 1993, 327) SV model is adopted to price two types of KIKO options. The paper proposes the iterated feasible two‐step estimation method, a technique for estimating the parameters in Heston's (Review of Financial Studies, 6, 1993, 327) model. Given constant fluctuations in volatility over time and the relatively long maturity of KIKO options, the SV model is more appropriate for evaluating long‐maturity KIKO options, the value of which depends heavily on volatility estimates for the constant‐volatility (CV) model. The results indicate that KIKO options considered in this paper are less attractive under the SV model than under the CV model, although it remains unclear whether the options are significantly overpriced.