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Ranjit Kumar1∗
1
Working as Quantitative Analyst in Investment Bank
Abstract
An attempt have been made to explain the mathematics underlying the Quanto effect in this
essay. The convexity adjustment manifests when an interest rate is paid out at the ”wrong” time
or in the ”wrong” currency [1]. Quanto adjustment also called as convexity adjustment has been
shown to result from changes in the numeraire from foreign to domestic risk-neutral measure. The
convexity adjustment also results from higher order derivative in stochastic calculations due to the
use of Ito’s calculus. Note that the convexity adjustments are quantified in terms of the variance
of the underlying process, it follows that implied volatility and time to maturity are its primary
determinants. Hence the convexity adjustment increases with the implied volatility and time to
maturity of the underlying. The convexity adjustment for the forward on driftless asset will be
presented in the next article in both the bond numeraire (T -forward measure) and money market
numeraire.
PACS numbers:
∗
Corresponding Author’s
E-Mail: du.ranjit@gmail.com
Tel: 91-9650289875
1
I. INTRODUCTION
II. CONVEXITY
In this section we will briefly discuss the convex function. A function f : Rn → R is convex
if
f (λx + (1 − λ)y) ≤ λf (x) + (1 − λ)f (y)
• eax
• − ln(x)
Note that if f (x) has a second derivative in [a, b], then a necessary and sufficient condition
00
for it to be convex on that interval is that the second derivative f (x) ≥ 0 for all x in [a, b].
2
FIG. 1: Example of a Convex Function. Geometrically, the line segment between any two points
on the graph of the function lies above the graph between the two points.
As an example let us consider Weiner process W (t) and a function f = f (W (t)). Then
using the Itô-Doeblin formula [4], we get
∂f (W (t)) 1 ∂ 2 f (W (t))
df (W (t)) = dW (t) + (dW (t))2 + Small Error
∂W (t) 2 ∂W (t)2
00
Note that the second order term 12 f (W (t)(dW (t))2 capture the curvature of the function.
Let
f (W (t)) = W 2 (t)
Then
df (W (t)) = 2W (t) dW (t) + dt + O t3/2
Let the stochastic differential equation for the asset is assumed to be of the form
Let us define
f (S(t)) = ln(S(t))
∂f (S(t)) 1 ∂ 2 f (S(t))
df (S(t)) = dS(t) + (dS(t))2 + Small Error
∂S(t) 2 ∂S(t)2
1
df (S(t)) = r dt + σs dW s (t) − σs2 dt + O t3/2
2
3
Integrating this equation, we obtain
2
σs
r− t+σs W s (t)
S(t) = S(0) e 2
s (t)
S(0) eσs W
2
is a martingale and hence the mean rate of return of asset is not equal to r − σ2 , it is equal
to r. Note that the convexity of the function eσx imparts an upward drift to S(0) eσs W .
s (t)
S(0) e− 2
t
σs ×σs ×ρs,s
S(0) e− 2
t
where ρs,s = 1, i.e., the correlation of stock return with itself. Thus the convexity correction
depends on the product of implied volatility of the underlying, the correlation between the
underlying and the time to maturity t. The convexity adjustment in general depends on
these three factors. If r = 0, then
Then
σs2
W s (t)−
S(t) = S(0) eσs 2
t
dS(t) = µ dt + σs dW s (t)
Note that there is no convexity adjustment in this case because we do not need a transfor-
mation like in the previous case.
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III. QUANTITY-ADJUSTING OPTION
A. Different Cases
where ST is the asset price in foreign currency, Kf is the strike price in foreign currency
and XT is the exchange rate.
where ST is the asset price in foreign currency, Kf is the strike price in foreign currency
and X is some pre-determined fixed exchange rate.
3. Struck: The struck is an option strategy on a foreign stock with strike in domestic
currency and the payout of this option in the domestic currency.
Please note that the Struck lead to squared payoffs. Also, the holder of a
composite option has exposure to the exchange rate.
We must estimate the stock price drift in domestic measure in order to price the quanto.
dSt = µs St dt + σs St dWts
5
From the perspective of a foreign investor with foreign cash account as numeraire, the foreign
asset’s risk neutral drift in this equation would be µst = rf and hence in foreign risk neutral
measure, this equation can be written as
f
dSt = rf St dt + σs St dWts
However, this is not true for domestic investor, since St is not the domestic price of a traded
asset nor is the foreign cash account a domestic numeraire. In fact it is Xt St that is the
domestic price of a traded asset.
d
dSt = µds St dt + σs St dWts
Consider a FX rate Xt , say EUR/USD. The value of the foreign money market account in
domestic currency is Btf Xt , and its discounted value in domestic currency is
f = Xt Btf
X t
Btd
Here, Xt B f denotes the foreign risk-free asset quoted in domestic currency and
dXt = µt Xt dt + σt Xt dWtx
6
We will show using Girsanov’s theorem, that by changing the measure P to an equivalent
domestic risk-neutral measure Qd that X
f is a Qd -martingale. Using Itô’s lemma
t
∂X
f
t ∂Xf
t ∂X f
t 1 ∂ 2X
f
t
dX
f
t = dXt + dB d
+ dB f
t + (dXt )2 + · · ·
∂Xt ∂Btd t
∂Bt f
2 ∂Xt 2
f f
B Xt B Xt
= td [µt Xt dt + σt Xt dWtx ] − d t2 rtd Btd dt + d rtf Btf dt
Bt (Bt ) Bt
h i
= µt + rtf − rtd X
f dt + σ X
t t t dWt
f x
= σt X
f dW
t
fd
t
where
Z t
fd
W t = Wtx + λu du
0
µt + rtf − rtd
λu =
σt
From Girsanov’s theorem, we know that there exist an equivalent risk-neutral measure Qd
on filtration Fs , 0 ≤ s ≤ t defined by Radon-Nikodỳm derivative
Rs Rs
λu dWux − 12 λ2u du
Zs = e −
0 0
dWtx = dW
f d − λ dt
t t
into
dXt = µt Xt dt + σt Xt dWtx
we get
dXt = rtd − rtf Xt dt + σt Xt dW
fd
t (1)
Note that if one consider exchange rate as asset, then it is dividend paying asset.
We know that the mean rate of return of exchange rate in domestic measure is rtd − rtf (see
Eq. (1)). When seen from a foreign prespective, the exchange rate is X1e . Also, one might
expect the mean rate of change of X1e to be rtf − rtd . Let
f = 1
f X t
X
f
t
7
Then
1 f + 1 f 00 X
d f = f0 Xf dX
t t
f dX
t
f2
Xt 2 t
1 h i
= f rtf − rtd + σt2 dt − σt dWfd
t (2)
Xt
Thus the mean rate of return under domestic measure is
f =− 1 f = 2
f0 X t
f2
and f 00 X f3
X t X t
If we switch to the foreign risk-neutral measure, which is the proper one for pricing derivative
security in the foreign currency, the imbalance caused by the convexity of f X
f = 1 is
X
e
resolved. See Ref. [4] for detailed discussion.
We know that
1 1 h
i
d f = f rtf − rtd + σt2 dt − σt dW
fd
t (3)
Xt Xt
Let
f f = dW
dW f d − σ dt
t t t
In terms of W
f f , we may rewrite Eq. (3) as
t
1 1 h
i
d f = f rtf − rtd dt − σt dW
ff
t
Xt Xt
As expected, under the foreign risk neutral measure, the mean rate of change for X1e is rtf −rtd .
The SDE for the non-dividend paying stock price quoted in foreign currency under P measure
is given by [3]
dSt = µs St dt + σs St dWts
8
We also have FX rate SDE as
dXt = µx Xt dt + σx St dWtx
and
dWts · dWtx = ρ dt
where
d d
ρ dt = dWtx · dWts
Thus
d(Xt St ) h d i d d
= µs + rd − rf + ρσs σx dt + σs dWts + σx dWtx
Xt St
Comparing with (4), we get
µds = rf − ρσx σs
σx dWtx + σs dWts
d d
f xs
dW t = q
σx2 + 2ρσs σx + σs2
9
where
µ = µx + µs + ρσs σx
q
σ = σs2 + σx2 + ρσs σx
σs dWts + σx dWtx
dWtxs = q
σs2 + σx2 + ρσs σx
Here Wtxs is a P-standard Weiner process.
2. Replication
Πt = φt Ut + ψt Btd
where φt and ψt are the units invested in Ut = Xt St and the risk-free asset Btd , respectively.
q
dΠt = φt (µx + µs + ρσs σx ) Ut dt + σs2 + σx2 + ρσs σx Ut dWtxs + ψt rd Btd dt
q
= r Πt dt + φt
d
µx + µs + ρσs σx − r d
Ut dt + σs2 + σx2 + ρσs σx Ut dWtxs
q
= rd Πt dt + φt σs2 + σx2 + ρσs σx Ut dW
f xs
t
where
f xs = λ t + W xs
W t t
with
µx + µs + ρσs σx
λ= q
σs2 + σx2 + ρσs σx
Finally, by substituting
dWtxs = dW
f xs − λ dt
t
into
d(Xt St ) q
= (µx + µs + ρσs σx ) dt + σs2 + σx2 + ρσs σx dWtxs
Xt St
The stock price diffusion process under the risk-neutral measure Qd becomes
d(Xt St ) q
= r dt + σs2 + σx2 + ρσs σx dW
d f xs
t
Xt St
Thus, under the domestic risk-neutral measure Qd
dSt f d
= r − ρ σx σs dt + σs dWts
St
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where rf is risk free rate in foreign currency, σx is volatility of FX rate, σs is volatility of
stock price and ρ is correlation between FX rate and stock price.
The drift term in domestic measure from above equation is given by [2]
rf − ρ σx σs (5)
A. Effect of Correlation
Let us consider an US investor who expects that British stock XYZ share price will
increase in one year. The US investor long a 1Y ATM call on British stock XYZ and wants
to get his return in USD and not in GBP. Assume that XYZ stock price is £ 5,
GBP
FX Rate = =2
USD
Thus
1 GBP = 2 USD
Let us assume that in one year time, the XYZ share price is worth £ 5.50. Then for plain
case
Payoff = max(ST − K) = £ 0.5
regardless of the change in exchange rate. Let us consider two different cases:
GBP
FX Rate = = 3.0
USD
11
Then the Payoff of without quanto call option would be
In this case, the GBP gets more valuable against the USD, XYZ price tends to increase.
The investor would then have been better of with a vanilla call. He is therefore short
this correlation.
GBP
FX Rate = = 1.5
USD
In this case, the GBP gets less valuable against the USD, XYZ price tends to increase.
The investor would then would be better of with a quanto call. He is therefore long
this correlation.
B. Effect of Volatility
dSt d d
= r − d dt + σs dWts
St
Therefore the price of a quanto option can be derived from a normal option by making
an adjustment to dividend yield
dSt d d
= r − rf + ρ σx σs dt + σs dWts
St
It is obvious from this equation that the FX volatility sensitivity is influenced by the
correlation’s sign. The holder of a quanto call (put) is long (short) FX volatility if the
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correlation is negative. The holder of a quanto call (put) is short (long) FX volatility
if the correlation is positive. It also emphasises the obvious principle that the implied
volatility of the underlying stock should be the same as the volatility utilised to price
the quanto option.
2. The changes in FX rates have an impact on the delta hedge. The delta hedge financing
will benefit if the price of the underlying stock doubles since one will be able to sell
more shares at a higher price and earn more interest as a result. However, the delta
hedge financing is actually unaffected if the correlation is such that a doubling in the
price of the underlying stock causes a halve of the EUR value versus the GBP.
We saw in the previous section how the change in measure is used to estimate stock drift
in domestic measures. In this section, we will estimate the drift of stock price in domestic
measure using the multivariate Girsanov theorem [6].
If
RT
1
||Θ(u)||2 du
E P
e 2 0 <∞
Then
Z t
f (t) = W (t) +
W Θ(u) du
0
13
and hence !
Z Z
dQ
Xt dQ = Xt dP, A ∈ Ft
A A dP Ft
Theorem: Let us consider a probability space (Ω, F, P) and a nonnegative random variable
Z satisfying
E P [Z] = 1
E Q [X] = E P [XZ]
= Xµ
e X dt + XΣTX dW
f X (t)
| {z }
New Drift
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Theorem: The new drift in the new measure is given by the following relation
d
e X = µX +
µ hln X, ln Zi
dt
In other words
d
ΣTX Θ(t) = hln X, ln Zi
dt
Proof: Since
* +
dX dZ
dhln X, ln Zi = ,
X Z
D E
= ΣTX dWX (t), ΘT (t)dW(t)
= ΣTX Θ(t) dt
where
hA, Bi = AT B
and
D E
AT dW(t), BT dW(t) = AT B dt
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This can be written as
" #
Qf −(rd −rf )τ Qd XT ST
E [ST |Ft ] = e E Ft
BTd
#
XT ST dQd
"
= e−(r )τ E Qf
d −r f
· Ft
Xt dQf
Now
XT = e(r −r )T +σx WT
d f
and
XT
= e(r −r )τ +σx (WT −Wt )
d f
Xt
Hence
dS
= rf dt + σs dWsf (t)
S
dQd
Z=
dQf
and hence
dQd
" #
Qf
Z(t) = E
dQf
From here we get
dZ
= −σx dWxf (t)
Z
When going from foreign to domestic measure, we need to find the new drift
* +
dS dZ
µ(t)
e = ,
S Z
D E
= σs dWSf (t), − σs dWxf (t)
= −σs σx ρ dt
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Hence
dS f
= r − ρσs σx dt + σs dWsd (t)
S
If we compare this equation with the Black-Scholes equation with a constant dividend yield
we see that pricing the quanto is equivalent to using a dividend yield of
rd − rf + ρσs σx
Note that there is an adjustment to a dividend yield. This yield depends on the volatility
of the exchange rate and the correlation between the underlying and the exchange rate.
Thus the change of measure from foreign to domestic measure introduces an extra term in
the exponential
e−ρσs σx T
CA = e−ρσs σx T − 1
If ρ = 0, we have
CA = 1 − 1 = 0
Define X to be the EUR/USD exchange rate (number of Euros per Dollar) and S is the
level of the Euro index [9]. We assume that they satisfy
dXt = µx Xt dt + σx Xt dWtx
dSt = µs St dt + σs St dWts
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with a correlation coefficient ρ between them. For hedging purpose, we construct a portfolio
that includes the Euro and the Euro index
Π = V (Xt , St , t) − ∆x X − ∆s XS
Note that every term in this equation is measured in domestic currency dollar. We short
∆x number of Euro. Note that −∆x X is the dollar value of that Euro. Similarly, with the
term ∆s XS we have converted the Euro-denominated index S into dollars. Again, ∆s is the
number of the index we hold short. The change in the value of the portfolio is due to the
change in the value of its components and the interest received on the Euro:
∂V 1 ∂ 2V ∂ 2V 1 2 2 ∂ 2V
dΠ = + σx2 Xt2 + ρσ σ X S
s x t t + σ S
∂t 2 ∂Xt2 ∂Xt ∂St 2 S t ∂St2
!
∂V
−ρσs σx ∆s St Xt − rf ∆x Xt dt + − ∆x − ∆s St dXt +
∂Xt
!
∂V
− ∆s Xt dSt
∂St
We now choose
∂V St ∂V
∆x = −
∂Xt Xt ∂St
1 ∂V
∆s =
Xt ∂St
to eliminate the risk in the portfolio. Setting the return on this riskless portfolio equal to
the US risk-free rate of interest rd , since Π is measured entirely in dollars, yields
∂V 1 ∂ 2V ∂ 2V 1 2 2 ∂ 2V
+ σx2 Xt2 + ρσ s σ x X t St + σ S +
∂t 2 ∂Xt2 ∂Xt ∂St 2 s t ∂St2
∂V d ∂V f
Xt r − rf + St r − ρσs σx − rd V = 0
∂Xt ∂St
This completes the formulation of the pricing equation. This equation is valid for both path-
independent and path-dependent cases. For both cases we need to specify the boundary
condition.
In this section we will discuss some of the quanto products and its pricing.
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A. Currency Forward
Let FtT denote the time t price of a forward contract for delivery of the foreign currency at
time T [8, 9]. Then since the initial value of the forward contract is 0, martingale pricing
implies
FtT − XT
" #
0=E Q
Ft
BT
which in turn implies
A forward FX rate FtT is usually quoted as a premium or discount to the spot rate Xt , via
the forward points.
B. Quanto Forward
XST is exchanged at maturity T for Kd unit of domestic currency. If we enter this contract
at time t, then Kt,d = Kd is chosen so that the initial value of contract is zero. Using
domestic cash account as numerare, we get
d
h dτ
i
0 = EQ e−r XST − Kt,d Ft
Hence
Kt,d = XSt e(r −ρσs σx )τ
f
This is the fair value of Quanto forward. Note that the convexity adjustment in this case is
e−ρσs σx τ − 1.
Consider a European call option on foreign asset, with strike Kd is set in the domestic
currency and the value of the foreign asset being converted to domestic currency at fixed
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exchange rate X. The payoff of quanto call is given by
Payoff = max X ST − Kd , 0
where St is foreign asset. The value of European call option is given by Black-Scholes formula
dτ
V (K, σ) = e−rdiv τ St N (d1 ) − e−r K N (d2 )
where rdiv is dividend on stock and rd is domestic interest rate. Since we know the dividend
for quanto, we may rewrite the above formula for quanto call as
where
σs2
ln + rf − ρσs σx +
XSt
Kd 2
τ
d1 = √
σs τ
√
d2 = d1 − σs τ
VII. SUMMARY
We have provided a step-by-step guide for figuring out the stock price’s drift in domestic
measure in this article. Three alternative techniques are used to estimate the stock price’s
drift. Convexity adjustment result from switching from changing foreign to domestic mea-
sures. In other words, convexity adjustment manifests when an interest rate is paid out in
the ”wrong” currency [1]. The convexity adjustment for the forward on driftless asset will
be provided in the next article.
VIII. ACKNOWLEDGEMENT
I would like to thank Abhishek Atreya for helpful discussion and motivating me to write
this article.
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[3] E. Chin, D. Nel and S. Ólafsson, Problem and Solutions in Mathematical Finance - Volume 2,
Wiley Finance Series, 2017.
[4] Steven E. Shreve, Stochastic Calculus For Finance II - Continuous-Time Models, Springer,
2004.
[5] Nicolas Privault, NTU Lectures.
https://personal.ntu.edu.sg/nprivault/indext.html
[6] Denis Papaioannou, Applied Multivariate Girsanov Theorem, 2012.
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1805984.
[7] Chia Chiang Tan, Demystifying Exotic Products – Interest Rates, Equities and Foreign Ex-
change, John Wiley & Sons Ltd., 2010.
[8] Martin Haugh, Foreign Exchange, ADR’S and Quanto-Securities, 2013.
http://www.columbia.edu/˜mh2078/ContinuousFE/FX_Quanto.pdf
[9] Paul Wilmott, Paul Wilmott Introduces Quantitative Finance, John Wiley & Sons Ltd., 2006.
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