FOURIER TRANSFORM METHOD WITH AN ASYMPTOTIC EXPANSION APPROACH: AN APPLICATION TO CURRENCY OPTIONS

Abstract

This paper develops a Fourier transform method with an asymptotic expansion approach for option pricing. The method is applied to European currency options with a libor market model of interest rates and jump-diffusion stochastic volatility models of spot exchange rates. In particular, we derive closed-form approximation formulas of the characteristic functions of log-prices of the underlying assets and the prices of currency options based on a third order asymptotic expansion scheme; we use a jump-diffusion model with a mean-reverting stochastic variance process such as in Heston [7]/Bates [1] and log-normal market models for domestic and foreign interest rates. Finally, the validity of our method is confirmed through numerical examples.

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