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Pricing derivatives on foreign assets using Markov-modulated cojump-diffusion dynamics

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  • Lian, Yu-Min
  • Chen, Jun-Home
  • Liao, Szu-Lang

Abstract

In this study, cross-currency derivatives pricing under stochastic interest rates is analyzed when Markov-modulated cojump-diffusion dynamics with both idiosyncratic and simultaneous jumps drive the underlying foreign equity price and foreign exchange rate processes. More specifically, the noise dynamics of these two assets are captured by the correlated Wiener processes, and the two types of jump events are described as two independent compound Poisson processes with log-normal jump amplitudes. Cojumping addresses the correlation between these two asset price jumps. In an incomplete market setting, the dynamic Esscher transform approach is applied to determine a pricing kernel. According to the resulting dynamics, explicit analytical formulas for evaluating values of European foreign equity call options are provided. Numerical experiments are also described.

Suggested Citation

  • Lian, Yu-Min & Chen, Jun-Home & Liao, Szu-Lang, 2024. "Pricing derivatives on foreign assets using Markov-modulated cojump-diffusion dynamics," International Review of Economics & Finance, Elsevier, vol. 93(PB), pages 503-519.
    • Handle: RePEc:eee:reveco:v:93:y:2024:i:pb:p:503-519
    DOI: 10.1016/j.iref.2024.04.030
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    More about this item

    Keywords

    Cross-currency derivatives; Foreign exchange rate; Simultaneous jump; Markov-modulated cojump-diffusion dynamics; Esscher transform;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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