Vanna-Volga Methods Applied to FX Derivatives: From Theory to Market Practice

Abstract:     
We study Vanna-Volga methods which are used to price first generation exotic options in the Foreign Exchange market. They are based on a rescaling of the correction to the Black-Scholes price through the so-called 'probability of survival' and the 'expected first exit time'. Since the methods rely heavily on the appropriate treatment of market data we also provide a summary of the relevant conventions. We offer a justification of the core technique for the case of vanilla options and show how to adapt it to the pricing of exotic options. Our results are compared to a large collection of indicative market prices and to more sophisticated models. Finally we propose a simple calibration method based on one-touch prices that allows the Vanna-Volga results to be in line with our pool of market data.

Number of Pages in PDF File: 28

Keywords: Vanna-Volga, Foreign Exchange, exotic options, market conventions

JEL Classification: C00

working papers series