國立臺灣大學管理學院財務金融學研究所

碩士論文
Graduate Institute of Finance College of Management
National Taiwan University
Master Thesis

運用倒數伽瑪分配評價匯率連動亞式選擇權
Pricing Exchange Rate-Linked Asian Options by the
Reciprocal Gamma Distribution Method

陳家隆
Chia-Lung Chen

指導教授：呂育道 博士
Advisor: Yuh-Dauh Lyuu, Ph.D.

中華民國 97 年 7 月
July 2008
 摘要

近年來，有諸多文章探討亞式選擇權的評價方式，譬如運用數值方法或是

使用近似封閉解等方式來加以探討。其中有 Milevsky and Posner (1998) 提出使

用倒數伽瑪分配來求取亞式選擇權的近似封閉解，在本論文中推廣此一方法於

評價匯率連動亞式選擇權。接著再運用蒙地卡羅模擬(Monte Carlo simulation)來

加以驗證本論文所提出之近似封閉解，結果得到相當準確的答案，因此相信本

論文可以提供有效之匯率連動亞式選擇權的近似封閉解。

關鍵詞：亞式選擇權、倒數伽瑪分配、匯率連動亞式選擇權、蒙地卡羅模擬。
 Abstract

In recent years, there has been a lot of research on the pricing of Asian options.

Examples include analytic approximation formulas and the binomial option pricing

model. Milevsky and Posner (1998) give a closed-form analytic approximation

expression for the value of the Asian option with the reciprocal gamma distributions.

In this thesis we extend the approximation formulas of Milevsky and Posner to value

two types of exchange rate-linked Asian options. To assess the accuracy of the

resulting prices, we use Monte Carlo simulation to establish the benchmarks. These

simulations show that the proposed solution is fairly accurate.

Key Words: reciprocal gamma distributions, exchange rate Asian options, Monte

Carlo simulation
 Table of Contents

Chapter 1 Introduction………………………………………………………...1

1.1 Introduction ……………………………….…….………………………………...1

1.2 Literature Review………………………….…….………………………………...3

1.3 Structure of the Thesis……………………………………………………………..4

Chapter 2 Background…………………………………………………………5

2.1 Models and Basic Results………………………………………………………5

2.2 Gamma Distributions…………………………………………………………...10

2.3 Reciprocal Gamma Distributions……………………………………………….11

Chapter 3 Analytic Approximation Formulas…………………...…...13

3.1 Floating Exchange Rate-Linked Asian Options….………………………………13

3.2 Fixed Exchange Rate-Linked Asian Options…………………………………….16

Chapter 4 Numerical Results…………………………………………...….20

Chapter 5 Conclusions and Future Works………………………….….23

Bibliography……………………………………………………………………..24
 List of Tables

Table 1. The results of the reciprocal gamma method compared with the Monte Carlo
method and the standard deviation of Monte Carlo………………………...21
Table 2. The sensitivity of the approximate closed-form solutions with the payoff of
the floating exchange rate-linked Asian call option………………………...22
Table 3. The sensitivity of the approximate closed-form solutions with the payoff of
the fixed exchange rate-linked Asian call option…………………………...23
Chapter 1
Introduction
1.1 Introduction

The global equity market offers products that link foreign stock and currency

exposures in many interesting ways. Investors may choose to combine their

investments in foreign equities with differing degrees of protection against adverse

moves in exchange rates, equity prices, or some combinations thereof.

These investors will encounter two types of risk when they invest overseas stock

markets, one is the price risk and the other one is the exchange rate risk. The price risk

is that the value of a security or portfolio of securities will decline in the future.

Exchange rate risk, also called currency risk, is the risk that changes in currencies will

reduce the value of investments denominated in a foreign currency. According to a

survey of Bank for International Settlements (BIS) by Stuart (2007), activities in OTC

derivatives markets continued to expand at a rapid pace. Average daily turnover of

interest rate and non-traditional foreign exchange contracts increase by 71% to 2.1

trillion US dollars in April 2007.

Investors may wish to have exposure to a foreign asset under the exchange rate

risk or not. Consider an investor who wants to participate in gains in a foreign equity,

desires protection against losses in that equity, but is otherwise unconcerned about the

exchange rate risk arising from a potential drop in the exchange rate. Such an investor

might desire the payoff of the floating exchange rate-linked option:

C f = X t max (S t − K ,0)

1
where S t is the foreign equity price at time t, K is the strike price and X t is the

exchange rate to convert the foreign currency into domestic currency at time t.

Another investor may want to capture upside returns on his foreign investment but

desire to hedge away all exchange risk by fixing in advance a rate at which the payoff

will be converted into domestic currency. Such an investor might desire the payoff of

the fixed exchange rate-linked option:

C d = X max (S t − K ,0)

where X is the pre-specified fixed exchange rate to convert the foreign currency into

domestic currency.

Let us move on to a derivative product that is of interest to investors or hedgers

concerned about the average price of the underlying asset. Asian options are path-

dependent contingent claims whose payoffs are based on the average price of the

foreign traded stock. Asian options are cheaper than the otherwise identical standard

options because the variance of the average is smaller than that of the price under the

standard Black-Scholes model. They are commonly traded on currencies and

commodity products which have low trading volumes. Milevsky and Posner (1998)

report that their outstanding volume is in the range of 5 to 10 billion US dollars. So

far all Asian options are OTC traded. The average feature can mitigate the

manipulation of option prices by deep-pocketed players. There are two averaging

methods associated with Asian options: geometric average and arithmetic average.

Only the arithmetic average is used in practice. The trouble with the arithmetic

average, however, is that it is not lognormally distributed under the Black-Scholes

model.

2
 Combining the strength of the Asian option and the exchange rate, the exchange

rate-linked Asian option will have desirable features from both. The payoff of the

exchange rate-linked Asian option is as follows:

C = X max (A[ 0,T ] − K ,0)

where A[ 0,T ] is the arithmetic average of the foreign equity price until the time T, K is

the strike price and X is the exchange rate to convert the foreign currency into

domestic currency.

1.2 Literature Review

Several approaches have been proposed to compute the price of option contracts

whose payoffs depend on the sum of lognormal variables. For example, for Asian

options, we find Monte Carlo simulation (Kemna and Vorst (1990), Fu, Madan and

Wang (2001)), lattice and PDE approaches (Hull and White (1993), Vecer (2001)),

pseudo-analytic characterizations (German and Yor (1993), Dufresne (2000), Nielsen

and Sandmann (2002)) and, finally, analytic approximations (Turnbull and Wakeman

(1991), Levy(1992), Vorst(1992), Bouaziz, Briys, and Crouchy (1994), Posner and

Milevsky(1998a), Milevsky and Posner(1998), Tsao, Chang and Lin (2003), Chang

and Tsao (2004)).

Analytic approximation formulas for the option value have the advantage in

being efficiently computable. Bouaziz, Briys, and Crouchy (1994) (hereafter referred

to as BBC) derive an analytic approximation formula for pricing Asian options using

the Taylor expansion. But the authors use only the first-order Taylor expansion in the

approximation. There are two problems in BBC as pointed out by Tsao, Chang and

Lin (2003), hereafter referred to as TCL. The first problem is that they only consider

the first-order term. The missing terms are important in the valuation of Asian options

3
and the missing terms will, in certain cases, induce large pricing errors or

unreasonable option values. The second problem is that the approximation formulas

of BBC can not accurately value an Asian option when the foreign traded stock price

has a large volatility, when the interest rate is high, or when the maturity is long.

TCL add the second-order term in the Taylor expansion. They then obtain a new

analytic approximation formula and show it outperforms the approximation formulas

of BBC in valuing Asian options under large volatilities and long maturities. Chang

and Tsao (2004) also add the second-order term in the Taylor expansion as TCL to

derive a better analytic approximation formula. They demonstrate that both BBC and

TCL are special cases of their approximation formulas.

Milevsky and Posner (1998) mention that the arithmetic average is a scaled sum

of correlated lognormal random variables for which there is no recognizable density

function. Consequently, there is no exact closed-form expression for valuing

arithmetic Asian options. In their paper, they derive the probability density function of

the infinite sum of correlated lognormal variables and show that it approximates a

reciprocal gamma distribution. This thesis extends this method in pricing exchange

rate-linked Asian options.

1.3 Structure of the Thesis

Chapter 2 describes fundamental theories, basic assumptions, the Asian option,

the gamma distribution and the reciprocal gamma distribution. Chapter 3 derives our

analytic approximation for different types of exchange rate-linked Asian options using

stochastic calculus and the reciprocal gamma distribution. Chapter 4 employs

numerical methods to verify this method’s accuracy and efficiency. Chapter 5

concludes.

4
Chapter 2

Background
2.1 Models and Basic Results

Below we list several standard assumptions.

1. The processes of the stock price and the exchange rate each follow a geometric

Brownian motion.

2. The trading of stock is continuous.

3. The stock is infinitely divisible.

4. There are no transactions costs or taxation.

5. Borrowing and lending are possible at the risk-free interest rate.

The process of the foreign stock price and exchange rate follow geometric

Brownian motions as follows:

dS
= μ S dt + σ S dZ
S
dX
= μ X dt + σ X dW
X

Above, S is the price of foreign traded stock in foreign currency, X is the exchange

rate defined as the units of the domestic currency divided by the units of the foreign

currency, μ S and μ X are the expected return of foreign traded stock and exchange

rate, σ S is the volatility of the foreign traded stock, σ X is the volatility of exchange

rate, dZ and dW are the increment of foreign traded stock’s and the exchange rate’s

standard Brownian motion.

Let f = f ( S t , X t ) be the price of derivative contingent on St and X t .

GX = X t St is the price of domestic traded stock. Using Ito’s Lemma, we have

5
 dGt
= (μ S + μ X + ρσ S σ X ) dt + σ S dz + σ X dW ,
Gt

⎛ dS dX ⎞
where ρ = Cov⎜ , ⎟ is the correlation coefficient of foreign traded stock and
⎝ S X ⎠
exchange rate.

Construct a portfolio consisting of the derivative (f), hedged with the exchange
rate (X) and the price of domestic traded stock (G):
H = f − Δ X X − Δ SG .

In order to produce a risk-free portfolio, we have to delete the risk factors dZ and

dW . We get the following partial differential equation in the process:

∂f ∂f ∂f 1 ∂2 f 2 2 1 ∂2 f 2 2 ∂2 f
rd f = + S (r f − ρσ S σ X ) + X ( rd − r f ) + S σS + X σX + XSρσ S σ X ,
∂t ∂S ∂X 2 ∂S 2
2 ∂X 2
∂S∂X

where rf is the foreign risk-free rate, rd is the domestic risk-free rate, and we let

∂f S ⎛ ∂f ⎞ 1 ⎛ ∂f ⎞
ΔX = − ⎜ ⎟ and Δ S = ⎜ ⎟ to eliminate the risk in the portfolio.
∂X X ⎝ ∂S ⎠ X ⎝ ∂S ⎠

According to the above preference-free equation, we have the process of the

foreign stock price from the viewpoint of the domestic investors and exchange rate

follow geometric Brownian motions under the risk-neutral probability measure as

follows:

= (rf − ρσ Sσ X ) dt + σ S dZ SQ
dS
S
= (rd − rf ) dt + σ X dWXQ
dX
X
dGt d ( X t St )
= = rd dt + σ S dZ SQ + σ X dWXQ
Gt X t St

where dZ SQ and dWXQ are the increment of foreign traded stock’s and the exchange

rate’s standard Brownian motion under the risk-neutral probability measure.

6
 In the presence of a continuous dividend yield q, we could generalize the above

equations to get the following equations:

= (rf − q − ρσ Sσ X ) dt + σ S dZ SQ
dS
S
= (rd − rf ) dt + σ X dWXQ
dX
X
dGt d ( X t St )
= = (rd − q ) dt + σ S dZ SQ + σ X dWXQ
Gt X t St

With Ito’s lemma and integration again, we have the processes of X , S and XS at

time T:

σS2
(rf −q−ρσSσX − )(T−t )+σS (ZTQ−ZtQ )
ST = St e 2 (1)
σX2
(rd −rf − )(T−t )+σX (WTQ−WtQ ) (2)
XT = Xt e 2

σS2 +σX2 +2ρσSσX

(rd −q− )(T−t )+σS (ZTQ−ZtQ )+σX (WTQ−WtQ )
XT ST = Xt St e 2

Use the above equations to obtain their expectations and the expectation of X T will

be used to derive the analytic approximation formulas in chapter 3:

( r f − q − ρσ S σ )( T − t )
E ( ST ) = Ste X

( rd − r f )( T − t )
E ( X T ) = X te (3)
( rd − q )( T − t )
E ( X T ST ) = X t Ste

The Asian option is defined and structured over the period of time [t , T ] . We

define the arithmetic sum of the continuous prices scaled by the current price as

1 T
I [ t ,T ] ≡
St ∫S t
u du (4)

Using Eq. (1), we rewrite Eq. (4) as follows:

σ 2
1 T ( r f − q − ρσ S σ − S
)( u − t ) + σ ( Z uQ − Z tQ )
= ∫
X S
I [ t ,T ] Ste 2
du
St t

σ 2
T ( r f − q − ρσ S σ − S
)( u − t ) + σ ( Z uQ − Z tQ )
= ∫
X S
e 2
du (5)
t

Define the arithmetic mean in continuous time as follows:

7
 1 T
A[ t ,T ] ≡
T − t ∫S t
u du (6)

Using Eq. (4), we can rewrite Eq. (6) as

St
A[ t ,T ] = I [ t ,T ] (7)
T −t

Technically, at any time t, 0 ≤ t ≤ T , we can decompose the stochastic variable A[ t ,T ]

into an observed and an unobserved part as follows:

t T −t
A[ 0 , T ] = A[ 0 , t ] + A[ t , T ] (8)
T T

In Eq. (8), A [ 0 , t ] is the observed average price until time t, and A[ t ,T ] is the average

price from time t to maturity T.

By the definition of expectation, E (A[ t ,T ] ) = ∫ A[ t ,T ] dQ , where Q is the risk-

Ω

neutral measure probability. Using Eq. (7) to replace A[ t ,T ] , we have

E (A [ t , T ] ) =
St
T −t ∫ Ω
I [ t , T ] dQ

Using Eq. (5) to replace I [ t ,T ] , we obtain

⎛ T ( r f − q − ρσ S σ X − σ S ⎞
2

E (A [ t , T ] ) =
St )( u − t ) + σ ( Z uQ − Z tQ )
∫Ω ⎜⎜ ∫t e du ⎟dQ
S
2
T −t ⎟
⎝ ⎠

Fubini’s Theorem (Arnold (1974)) 1 can be used to change the order of integration as

follows:

(∫ e )
σ 2

E (A [ t ,T ] ) =
St T ( r f − q − ρσ Sσ X − S
)( u − t )
∫
σ ( Z uQ − Z tQ )
e 2 S
dQ du
T −t t Ω

1
In mathematical analysis, Fubini’s Theorem, named after Guido Fubini, states that if

∫ AXB
f(x, y) d ( x, y ) < ∞
the integral being taken with respect to a product measure on the space over A×B, where A and B are
complete measure spaces, then

∫ (∫
A B
)
f ( x, y ) dy dx = ∫
B
(∫ A
f ( x, y ) dx dy = ∫ ) A× B
f ( x, y ) d ( x, y )

8
As Z uQ − Z tQ ~ N ( 0 , u − t ) , we can use the moment generating function of the normal

distribution to obtain ∫ eσ S ( Zu − Zt ) dQ = eσ S (u −t ) / 2 . So
Q Q 2

σ S2 σ S2
E (A[ t , T ] ) =
St T ( r f − q − ρσ S σ − )( u − t ) (u − t ) St T ( r f − q − ρσ S σ
∫ ∫
)( u − t )
du =
X
e 2
e 2
e X
du
T −t t T −t t

Finally, integrate to get

E (A[ t ,T ] ) =
St
( T − t )( r f − q − ρσ S σ X )
( r − q − ρσ S σ X )( T − t )
e f −1 ( ) (9)

By the definition of expectation, we have E (X T A[ t , T ] ) = ∫ X T A[ t , T ] dQ , where

Ω

Q is the risk-neutral measure probability. Using Eqs. (2) and (7) to replace X T A[ t ,T ] ,

we have

σ 2

⎛ St ⎞
E ( X T A[ t , T ] ) =
( rd − r f − X
)( T − t ) + σ ( W TQ − W t Q )
∫
X
X te 2
⎜ I [ t , T ] ⎟dQ
Ω
⎝T −t ⎠

Use Eq. (5) to replace I [ t , T ] to yield

⎛ S T ( r f − q − ρσ S σ X − σ S )(u − t ) +σ S ( Z uQ − Z tQ ) ⎞
σ X2 2

E (X T A[ t ,T ] ) = ∫ X t e
( rd − r f − )(T − t ) + σ X (WTQ −WtQ )
⎜ t du ⎟dQ
⎜ T − t ∫t
2
e 2
Ω ⎟
⎝ ⎠
Fubini’s Theorem (Arnold (1974)) can be used to change the order of integration as

follows:

(∫ )
σ 2
σ S2
E (X T A[ t ,T ] ) = t t
X S T ( rd − q − ρσ S σ − X
− )( u − t )
∫
Q
− Z tQ ) + σ ( W uQ − W t Q )
eσ S ( Z u
X
e 2 2 X
dQ du
T −t t Ω

As Z uQ − Z tQ ~ N (0, u − t ) and WuQ − Wt Q ~ N ( 0, u − t ) , by the additivity of normal

distributions, we have

σ S ( Z uQ − Z tQ ) + σ X (WuQ − Wt Q ) ~ N (0, σ S2 (u − t ) + 2 ρσ S σ X (u − t ) + σ X2 (u − t ))

From the moment generating function of normal distribution,

1
(σ 2
( u − t ) + 2 ρσ S σ X ( u − t ) + σ X2 ( u − t ) )
∫
Q
− Z tQ ) + σ X ( WuQ −W t Q )
eσ S ( Z u dQ = e 2
S

9
Rearrange the above equation to yield

E (X T A [ t , T ] ) =
X tSt T
∫
− q )( u − t )
e ( rd du
T − t t

Finally, integrate to get

E (X T A[ t ,T ] ) =
X tSt
(T − t )( rd − q )
(
e ( rd − q )( T − t ) − 1 ) (10)

2.2 Gamma Distributions

In this section we introduce the gamma distributions. It is proved in advanced

calculus that the integral

∞
∫0
y α −1e − y dy

exists for α > 0 and that the value of the integral is a positive number. The integral is

called the gamma function of α , and we write

∞
Γ (α ) = ∫ 0
y α −1e − y dy

If α = 1 , clearly

∞
Γ (1) = ∫ e − y dy = 1
0

If α > 1, , integration by parts shows that

∞
Γ (α ) = (α − 1) ∫ y α − 2 e − y dy = (α − 1) Γ (α − 1)
0

Accordingly, if α is a positive integer greater than 1,

Γ (α ) = (α − 1) (α − 2 ) L (3)(2)(1) Γ (1) = (α − 1)!

Since Γ(1) = 1, this suggests that we take 0!= 1, as we have done.

In the integral that defines Γ(α ), let us introduce a new variable x by writing

x
y= , where β > 0. Then
β

10
 α −1 x
∞ ⎛x⎞ − ⎛1 ⎞
Γ (α ) = ∫ ⎜⎜ ⎟⎟ e β
⎜⎜ ⎟⎟ dx
0
⎝β⎠ ⎝β ⎠

or, equivalently,

x
∞ 1 −

∫
α −1 β
1= α
x e dx
0 Γ (α ) β

Since α > 0, β > 0 and Γ(α ) > 0, we see that

⎧ 1 α −1 β
−
x

⎪ x e , 0< x<∞
f X ( x ) = ⎨ Γ(α ) β α
⎪0
⎩ , elsewhere

is a probability density function (p.d.f.) of a random variable of the continuous type.

A random variable X that has a p.d.f. of this form is said to have a gamma distribution

with parameters α and β or simply X ~ Γ(α , β ) . Any such f X (x) is called a

u
x 1 −

∫ u α −1 e β
gamma-type p.d.f. Finally, F X ( x ) = α
du is the cumulative
0 Γ (α ) β

distribution function (c.d.f.) of X.

2.3 Reciprocal Gamma Distributions

1
Y is called the reciprocal gamma distribution if Y = , where X ~ Γ(α , β ) .
X

Define fY ( y | α , β ) as the p.d.f. of Y and FY ( y | α , β ) as the c.d.f. of Y. Since

1 1 1
FY ( y | α , β ) = P (Y ≤ y ) , with Y = we have FY ( y | α , β ) = P( ≤ ) and since
X X x

P ( X ≥ x ) = 1 − P ( X ≤ x ) , we have FY ( y | α , β ) = 1 − FX ( x | α , β ) .

∂ ∂
We also have FY ( y | α , β ) = fY ( y | α , β ) = − FX ( x | α , β ) by calculus and
∂y ∂y

∂ x 1
fY ( y |α , β ) = −
∂y ∫0
f X ( u | α , β ) du . Because Y =
X
, we have

11
 ∂ 1
fY ( y | α , β ) = −
∂y ∫
0
y
f X ( u | α , β ) du . By Leibniz’s law, we have

⎛1 ⎞⎛ 1 ⎞
f Y ( y | α , β ) = − f X ⎜⎜ | α , β ⎟⎟ ⎜⎜ − 2 ⎟⎟ . Finally,
⎝ y ⎠⎝ y ⎠

⎛1 ⎞
fX ⎜ |α ,β ⎟
fY ( y | α , β ) = ⎝ y ⎠ (11)
y2

The above equation states the transformation between the reciprocal gamma

distribution and the gamma distribution.

12
Chapter 3

Analytic Approximation Formulas

3.1 Floating Exchange Rate-Linked Asian Options

The payoff of the floating exchange rate-linked Asian call option at maturity

depends on the exchange rate at that time. Hence the payoff depends on an extra

uncertainty rate. The no-arbitrage value of the Asian call option is the discounted

expectation of the payoff using the risk-neutral measure,

C1 = e − rd (T − t ) E[ X T max( A[ 0,T ] − K ,0)] (12)

By Eq. (12), use Eq. (8) to replace A[ 0,T ] and obtain

⎡ ⎛T −t ⎛ t ⎞ ⎞⎤
C 1 = e − rd ( T − t ) E ⎢ X T m ax ⎜ A[ t ,T ] − ⎜ K − A[ 0 , t ] ⎟ , 0 ⎟ ⎥
⎣ ⎝ T ⎝ T ⎠ ⎠⎦

Rearrange the equation, we have

⎛T −t ⎞
C1 = e −rd ( T −t ) ⎜ ⎟ E[ X T max( A[ t ,T ] − K ′,0)] (13)
⎝ T ⎠

TK − tA[ 0 ,t ]
where K ′ = .
T −t

The following theorem approximates the price of the floating exchange rate-

linked Asian call option by evaluating this expectation under the risk-neutral measure,

with the help of the reciprocal gamma distribution.

Theorem 1. The no-arbitrage value of the floating exchange rate-linked Asian call

option can be of two different types.

(1) If K ′ ≤ 0 in Eq. (13), then we have the following expression:

13
 TK − tA [ 0 , t ]
C1 =
X t St
T ( rd − q )
[ ]
e − q ( T − t ) − e − rd ( T − t ) −
T
− r (T − t )
X te f

(2) If K ′ > 0 in Eq. (13), then we have the following expression:

~ e − r f (T − t ) X ⎛⎜ T − t ⎞⎟ ⎡
C1 =
1 ⎛ 1
FX ⎜
⎞ ⎛ 1
| α − 1, β ⎟ − K ′FX ⎜
⎞⎤
| α , β ⎟⎥
⎢
⎝ T ⎠ ⎣ β (α − 1) ⎝ K ′ ⎝ K′
t
⎠ ⎠⎦

where FX is the c.d.f. of the gamma distribution.

Proof.

TK
Case 1: K ′ ≤ 0 , which also means A[ 0,t ] ≥ .
t

⎛T −t ⎞
In Eq. (13), C1 = e − rd (T −t ) ⎜ ⎟ E[ X T max( A[ t ,T ] − K ′, 0)] . A[ t ,T ] − K ′ is positive
⎝ T ⎠

since K ′ ≤ 0 . We can rewrite the above equation as

⎛T −t⎞
C 1 = e − rd ( T − t ) ⎜ ⎟ E [ X T ( A[ t ,T ] − K ′)]
⎝ T ⎠

Use the linearity of expectation to get

⎛T − t⎞
C1 = e − rd ( T − t ) ⎜ ⎟[ E ( X T A[ t ,T ] ) − K ′E ( X T ))]
⎝ T ⎠

With Eqs. (10) and (3) replacing E ( X T A[ t ,T ] ) and E ( X T ) , we have

⎛ T − t ⎞⎡ X t St ( r − r )( T − t ) ⎤
C1 = e − rd (T − t ) ⎜ ⎟⎢ ( e ( rd − q )( T − t ) − 1) − K ′X t e d f ⎥
⎝ T ⎠ ⎣ (T − t )( rd − q ) ⎦

Finally, it is easy to prove

TK − tA [ 0 , t ]
C1 =
X t St
T ( rd − q )
[ ]
e − q ( T − t ) − e − rd ( T − t ) −
T
− r (T − t )
X te f

TK
Case 2: K ′ > 0 , which also means A[ 0 , t ] < .
t

14
 ⎛T −t ⎞
In Eq. (13), C1 = e −rd ( T −t ) ⎜ ⎟ E[ X T max( A[ t ,T ] − K ′,0)] . Use Eq. (2) to replace
⎝ T ⎠

X T , then

⎛T −t ⎞ ⎡ ⎤
σ 2
( rd − r f − X )( T − t ) + σ X ( w TQ − w tQ )
C1 = e − rd ( T − t )
⎜ ⎟E ⎢ X te 2
max( A[ t ,T ] − K ′, 0 ) ⎥
⎝ T ⎠ ⎢⎣ ⎥⎦

σ 2
1 T
− X
(T − t ) +σ ( w TQ − w tQ ) − ∫ σ
2
dt + ∫tT σ dW Q

Let ζ T − t = e = e
X X X
2 2 t
and use the

Girsanov theorem, we get

⎛T −t ⎞ R
C1 = e − rd ( T −t ) ⎜
⎝ T ⎠
⎟E X t e [
( rd − r f )( T −t )
max( A[ t ,T ] − K ′,0) ]
E R [⋅] is the expected value under the R-measure. The R-measure here is

meaningless in finance; it just convenient to apply the Girsanov theorem which

can be used to transform probability measure. Rewrite the above equation to

obtain

⎛T −t⎞ R
⎟ E [max( A[ t ,T ] − K ′,0 ) ]
− rf ( T −t )
C1 = e Xt⎜
⎝ T ⎠

Let y = A[ t ,T ] . Then y approximates fY ( y | α , β ) by the results of Milevsky and

Posner (1998). 2 Then

⎛T −t⎞ ∞
⎟ ∫ ( y − K ′ ) f Y ( y | α , β ) dy
−r (T − t )
= e f
C1 ~ X t⎜
⎝ T ⎠ K′

1 1
Let Y = and differentiate both sides of the equation to get dx = − 2 dy . Then
X y

we have

1 2 1 T
2
If r − q −
2
σ S < 0 , then lim I [ t , T ] = lim
T→∞ T→∞ S
t
∫ t
S u du ~ f Y ( y | α , β ) with

2(q − r ) σ S2
parameters α = 1+ > 0 and β = . Furthermore, A[ t ,T ] ~ fY ( y | α , β ) .
σ S2 2

15
 ⎛ T − t ⎞ K′⎛ 1 ⎞
1

⎟ ∫0 ⎜ − K ′ ⎟ f Y ( y | α , β ) y dx
−r (T − t )
= e f
C1 ~ X t⎜ 2

⎝ T ⎠ ⎝ x ⎠

Because f Y ( y | α , β ) y 2 = f X ( x | α , β ) by Eq. (11), we have

~ e − r f ( T − t ) X ⎛⎜ T − t ⎞⎟ K ′ ⎡ 1 f ( x | α , β ) − K ′f ( x | α , β ) ⎤dx
1
C1 = t ∫
⎝ T ⎠ 0 ⎢⎣ x
X X ⎥⎦

Finally, it is easy to prove

⎛ T − t ⎞⎡ K ′ ⎤
1 x 1
1 −
⎟ ⎢ ∫0 ∫0 X
− r f (T − t ) ( α − 1) − 1
C1 = e
~ Xt⎜ α
x e β
dx − K ′ K′
f ( x | α , β ) dx ⎥
⎝ T ⎠ ⎢⎣ Γ(α ) β ⎥⎦

and

~ e − r f ( T − t ) X ⎛⎜ T − t ⎞⎟ ⎡
C1 =
1 ⎛ 1
FX ⎜
⎞ ⎛ 1
| α − 1, β ⎟ − K ′FX ⎜
⎞⎤
| α , β ⎟⎥
⎢
⎝ T ⎠ ⎣ β (α − 1) ⎝ K ′ ⎝ K′
t
⎠ ⎠⎦

3.2 Fixed Exchange Rate-Linked Asian Options

The payoff of the fixed exchange rate-linked Asian call option at maturity

depends on the pre-specified fixed exchange rate ( X ) at the issue day. Hence this

exotic option avoids the effect on exchange rate’s fluctuations. The no-arbitrage value

of the Asian call option is the discounted expectation of the payoff using the risk-

neutral measure,

[
C 2 = e − rd ( T − t ) E X max( A[ 0 ,T ] − K ,0) ] (14)

By Eq. (14), use (8) to replace A[ 0,T ] and obtain

⎡ ⎛T − t ⎛ t ⎞ ⎞⎤
C 2 = e − rd ( T − t ) E ⎢ X max ⎜ A [ t ,T ] − ⎜ K − A [ 0 ,t ] ⎟ , 0 ⎟ ⎥
⎣ ⎝ T ⎝ T ⎠ ⎠⎦

Rearrange the equation and the pre-specified fixed exchange rate ( X ) is not a random

variable, we have

16
 ⎛T −t⎞
C2 = e −rd ( T −t ) ⎜ ⎟ X E [max( A[ t ,T ] − K ′,0)] (15)
⎝ T ⎠

TK − tA [ 0 ,t ]
where K ′ = .
T −t

The following theorem approximates the price of the fixed exchange rate-linked

Asian call option by evaluating this expectation under the risk-neutral measure, with

the help of the reciprocal gamma distribution.

Theorem 2. The no-arbitrage value of the fixed exchange rate-linked Asian call

option can be two different types as following.

(1) If K ′ ≤ 0 in Eq. (15), then we have the following expression:

⎛ T − t ⎞⎡
C 2 = e − rd ( T − t ) X ⎜ ⎟⎢
St
(
(( r − q − ρσ S σ X )( T − t ) )
e f ) ⎤
− 1 − K '⎥
⎝ T ⎠ ⎢⎣ (T − t )( r f − q − ρσ S σ X ) ⎥⎦

(2) If K ′ > 0 in Eq. (15), then we have the following expression:

~ e − rd ( T − t ) X ⎛⎜ T − t ⎞⎟ ⎡ 1 ⎛ 1 ⎞ ⎛ 1 ⎞⎤
C2 = ⎢ FX ⎜ | α − 1, β ⎟ − K ′F X ⎜ |α,β ⎟⎥
⎝ T ⎠ ⎣ β (α − 1) ⎝ K′ ⎠ ⎝ K′ ⎠⎦

where FX is the c.d.f. of the gamma distribution

Proof.

TK
Case 1: K ′ ≤ 0 , which also means A[ 0 ,t ] ≥ .
t

⎛T −t⎞
In Eq. (15), C 2 = e − rd ( T − t ) ⎜ ⎟ X E [max( A[ t ,T ] − K ′,0) ] . A[ t ,T ] − K ′ is positive
⎝ T ⎠

since K ′ ≤ 0 . We can rewrite the above equation as

⎛T −t ⎞
C 2 = e − rd ( T −t ) ⎜ ⎟ X E [A[ t ,T ] − K ′]
⎝ T ⎠

Use the linearity of expectation to get

⎛T −t ⎞
C 2 = e − rd ( T −t ) ⎜ ⎟ X [E ( A[ t ,T ] ) − K ′]
⎝ T ⎠

17
 With Eq. (9) replacing E (A[ t ,T ] ) , we have

⎛ T − t ⎞⎡
C 2 = e − rd ( T − t ) X ⎜ ⎟⎢
St
(
(( r − q − ρσ S σ X )( T − t ) )
e f ) ⎤
− 1 − K '⎥
⎝ T ⎠ ⎣ (T − t )( rf − q − ρσ S σ X ) ⎦

TK
Case 2: K ′ > 0 , which also means A[ 0 , t ] < . In Eq. (15),
t

⎛T −
⎟ X E [max( A[ t ,T ] − K ′,0 ) ]
t⎞
C 2 = e − rd ( T − t ) ⎜
⎝ T ⎠

Let y = A[ t ,T ] . Then y approximates fY ( y | α , β ) by the results of Milevsky and

Posner (1998). Then

~ e − rd ( T − t ) ⎛⎜ T − t ⎞⎟ X ∞
C2 =
⎝ T ⎠
∫ ( y − K ′) f ( y | α , β )dy
K′
Y

1 1
Let X = and differentiate both sides of the equation to get dx = − 2 dy . Then
Y y

we have

⎛T −t⎞ ⎛1 ⎞
1
= e − rd ( T − t ) ⎜
C2 ~ ⎟X ∫ K′
⎜ − K ′ ⎟ f Y ( y | α , β ) y dx
2

⎝ T ⎠ 0
⎝x ⎠

Because fY ( y | α , β ) y 2 = f X ( x | α , β ) by Eq. (11), we have

~ e − rd ( T − t ) ⎛⎜ T − t ⎞⎟ X K ′ ⎡ 1 f ( x | α , β ) − K ′f ( x | α , β ) ⎤dx
1
C2 =
⎝ T ⎠ 0 ⎢⎣ x
∫ X X ⎥⎦

Finally, it is easy to prove

− rd ( T − t ) T − t
⎡ 1 1 −
x 1 ⎤
C2 = e
~ ( ) X ⎢∫ K′
α
x ( α − 1) − 1
e β
dx − K ′ ∫ K′
f X ( x | α , β ) dx ⎥
T ⎢⎣ 0 Γ(α ) β 0
⎥⎦

and

~ e − rd ( T − t ) ⎛⎜ T − t ⎞⎟ X ⎡
C2 =
1 ⎛ 1
FX ⎜
⎞ ⎛ 1
| α − 1, β ⎟ − K ′FX ⎜
⎞⎤
| α , β ⎟⎥
⎢
⎝ T ⎠ ⎣ β (α − 1) ⎝ K ′ ⎠ ⎝ K′ ⎠⎦

When the fixed exchange rate equals 1 and the correlation coefficient between

the foreign stock price and the exchange rate, ρ , equals 0, then our approximation

18
formulas is the same as the approximation formulas of the Milevsky and Posner. So

we get that the approximation formulas of the Milevsky and Posner is a special case

in our approximation formulas.

19
Chapter 4

Numerical Results
In this chapter, we adopt the Monte Carlo simulation as benchmarks to compare

the pricing accuracy of the analytic approximation formulas in Chapter 3. The Monte

Carlo approach offers the obvious advantage that the estimated value and its standard

deviation are simultaneously derived so that the accuracy of the results can be

established.

We assume that the current foreign stock price equals 100 ( St = 100 ), the current

exchange rate equals 32 ( X t = 32 ), and the time to maturity of option is half year

( T = 0.5 ). Assume the current time is 160 days ( t = 160 / 360 ) from the beginning of

the contract. Additionally, we let the volatility of foreign stock price return ( σ S ) equal

0.25, the volatility of exchange rate ( σ X ) equal 0.2, the correlation coefficient

between the foreign stock price and the exchange rate, ρ , equal 0.5, and the

continuous dividend ( q ) equal 0.2. We adopt Monte Carlo simulation with time

intervals of one day and 20,000 iterations to calculate all benchmark option values.

These parameters are similar to Chang and Tsao (2004).

Table 1. The results of the reciprocal gamma method compared with the Monte Carlo
method and the standard deviation of Monte Carlo.
standard deviation of
reciprocal gamma Monte Carlo errors 3
Monte Carlo
C1 7.683442 7.622958 0.79% 0.046656
C2 7.548050 7.534645 0.17% 0.046634

3
errors=(the result of reciprocal gamma － the result of Monte Carlo) / the result of Monte Carlo.

20
 Table 1 demonstrates that our procedure is fairly robust. The first reason is the

standard deviation of Monte Carlo method is less than 0.05, which means that the

Monte Carlo method’s results are accurate. The second reason is the errors between

the reciprocal gamma method and the Monte Carlo method are less than 1% given the

accurate Monte Carlo method’s results. The robustness of the approximate pricing

formula apparently indicates that it is a reliable method for approximating the value of

exchange rate-linked Asian options.

Table 2. The sensitivity of the approximate closed-form solutions with C1 .

Parameters ρ =0.5, σ X =0.2

The strike σ S =0.1 σ S =0.2 σ S =0.3 σ S =0.4

price

K = 90 3.141090 6.204275 9.116525 11.81770

K = 100 1.18684E-13 0.001077 0.139401 0.982940
K = 110 7.42971E-19 5.1404E-05 0.035359 0.450650

In Tables 2, we observe the payoff of the floating exchange rate-linked Asian

call option ( C1 ) and we fix the correlation coefficient between the foreign stock price
and the exchange rate, ρ , and the volatility of exchange rate ( σ X ). Then we observe
the change in option prices under different strike prices and volatilities of foreign
stock price. First, with the same foreign stock price volatility, the option’s price is
smaller when the strike price becomes large. Second, with the same strike price, the
option’s price is bigger when the volatility of foreign stock price becomes larger.

21
Table 3. The sensitivity of the approximate closed-form solutions with C2 .

Parameters ρ =0.5, σ X =0.2

The strike σ S =0.1 σ S =0.2 σ S =0.3 σ S =0.4

price

K = 90 3.379380 6.188010 8.866815 11.354817

K = 100 1.17155E-13 0.001023 0.131536 0.925133
K = 110 7.16775E-19 4.85615E-05 0.033273 0.423483

In Tables 3, we also observe the payoff of the fixed exchange rate-linked Asian
call option ( C2 ). Then we obtain the same results as in Tables 2. So the above results
mean that the option is more valuable for the in-the-money situation and the large
volatility of foreign stock price.

22
Chapter 5

Conclusions and Future Works

In this thesis, we extend the approximation formulas of the Milevsky and Posner

(1998) to value two types of exchange rate-linked Asian options. The approximation

formulas of the Milevsky and Posner consider only the pricing of Asian options. This

thesis considers the more general problem of the pricing of exchange rate-linked

Asian options. When the fixed exchange rate equals 1 and the correlation coefficient

between the foreign stock price and the exchange rate, ρ , equals 0, the approximation

formulas of the Milevsky and Posner become special cases of our approximation

formulas. We derive a closed-form analytic approximation expression different from

the BBC approximation formulas for the value of exchange rate-linked Asian options.

To assess the accuracy of the resulting prices, we use Monte Carlo simulation to

establish benchmarks. These simulations show that the proposed solution is fairly

accurate. In summary, we have derived an analytic approximation solution for

exchange rate-linked Asian options that performs quite well and is computationally

efficient.

Future work can consider pricing forward-starting exchange rate-linked Asian

options. The forward-starting Asian option is a slightly generalized form of the Asian

option. Its payoff is based on the average price from a certain time after the issue day.

23
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