Expansion formulas for European quanto options in a local volatility FX-LIBOR model

TL;DR

This paper introduces an expansion method for pricing European quanto options on LIBOR rates within a local volatility FX-LIBOR model, providing rapid and accurate approximations with error estimates.

Contribution

It develops a novel expansion approach for quanto option pricing under local volatility models, enabling fast computations and error control.

Findings

Expansion formulas closely match numerical benchmarks

Method captures skew/smile effects in FX and fixed income markets

Error estimates improve pricing reliability

Abstract

We develop an expansion approach for the pricing of European quanto options written on LIBOR rates (of a foreign currency). We derive the dynamics of the system of foreign LIBOR rates under the domestic forward measure and then consider the price of the quanto option. In order to take the skew/smile effect observed in fixed income and FX markets into account, we consider local volatility models for both the LIBOR and the FX rate. Because of the structure of the local volatility function, a closed form solution for quanto option prices does not exist. Using expansions around a proxy related to log-normal dynamics, we derive approximation formulas of Black--Scholes type for the price, that have the benefit of giving very rapid numerical procedures. Our expansion formulas have the major advantage that they allow for an accurate estimation of the error, using Malliavin calculus, which is directly related to the maturity of the option, the payoff, and the level and curvature of the local volatility function. These expansions also illustrate the impact of the quanto drift adjustment, while the numerical experiments show an excellent accuracy.