Pricing Quanto and Composite Contracts with Local-Correlation Models

TL;DR

This paper investigates local-correlation models for pricing composite and quanto contracts, proposing online calibration methods and comparing their effectiveness to simpler correlation approximations.

Contribution

It introduces novel online calibration procedures for local and stochastic volatility models tailored to joint asset and exchange rate modeling.

Findings

Calibration procedures perform well in numerical tests

Local-correlation models improve pricing accuracy

Compared methods outperform simpler correlation approximations

Abstract

Pricing composite and quanto contracts requires a joint model of both the underlying asset and the exchange rate. In this contribution, we explore the potential of local-correlation models to address the challenges of calibrating synthetic quanto forward contracts and composite options quoted in the market. Specifically, we design on-line calibration procedures for generic local and stochastic volatility models. The paper concludes with a numerical study assessing the calibration performance of these methodologies and comparing them to simpler approximations of the correlation structure.