Quanto Implied Correlation in a Multi-Lévy Framework

Abstract

In this paper we apply the multivariate construction for Lévy processes introduced by Ballotta and Bonfiglioli (2014) to propose an integrated model for the joint dynamics of FX exchange rates and asset prices. We show that the proposed construction is consistent in terms of symmetries with respect to inversion and triangulation, and provides an insight into the quanto adjustment showing that this is affected by higher order cumulants of the pure jump part of the systematic risk factor. Using the Esscher transform, we relate Quanto options to vanilla call and put options, which allows for a fast calibration method to the vanilla and the Quanto market. As Quanto products offer significant exposure to the correlation between exchange rates and asset prices, they allow access to a market implied measure of this correlation. By means of a joint calibration exercise to the CME USD denominated Quanto futures on the Nikkei 225 index and both the Nikkei 225 and USDJPY market implied volatilities, we illustrate this approach for the case in which the driving process is assumed to be a Variance Gamma process.

Keywords: FX risk, implied correlation, multivariate Lévy processes, Quanto products, triangular relation, Variance Gamma process

JEL Classification: G13, G12, C63, D52