Q t R t R f t dt 2 t dW3 t
9.3.16
Example:
Exchange rate of 0.9 euros to the dollar:
1 euro 1.1111 dollars
If the dollar price of euro falls by 5%:
1 euro 0.95 1.1111 = 1.0556 dollars
This is an exchange rate of 1/1.0556=0.9474 euros to
dollars. The change from 0.9 euros to the dollar to
0.9474 euros to the dollar is a 5.26% ( = 1/0.95 - 1)
increase in the euro price of the dollar, not a 5% increase.
We take f x
1
1
2
so that f x 2 and f x 3 . Using 9.3.16 , we obtain
x
x
x
1
d df Q
Q
f Q dQ
1
f Q dQdQ
2
1
1
R f R dt 2 dW3 22 dW3dW3
Q
Q
1
R f R 22 dt 2 dW3
Q t
9.3.24
1
is resolved if we
x
switch to the foreign risk-neutal measure, which is the appropriate one for derivative
However, the asymmetry introduced by the convexity of f x
security pricing in the foreign currency. First recall the relaptionship (9.3.20)
dW3
In terms of W3
Q Q
Under the foreign risk-neutral measure, the mean rate of change for
as expect.
(9.3.25)
1
is R f R,
Q
9.3.4
1 1
1
2
d
t
dt
2 t dW3 t
9.3.27
2
Q t
Q t Q t
1
Both Q and
have the same volatility. However, the mean rates of change
Q
1
of Q and
are not negatives of one another.
Q
Therefore
money market account
r r f t
e
Q t
money market account
is a martingale under P , the domestic risk-neutral measure.
proof :
r r f t
d e
Q t
r r
r r
r r f t
e
e
dt Q t e
Q t dt e
r r f t
r r f t
Q t 2 t dW 3 t
r r f t
r r f t
dQ t
Q t r r f dt 2 t dW 3 t
At time zero, the (domestic currency) forward price F for a unit of foreign
currency, to be delivered at time T , is determined by the equation
E e rT Q T F 0
The left-hand side is the risk-neutral pricing formula applied to the derivative
security that pays Q T in exchange for F at time T . Setting this equal to zero
determines the forward price. We may solve this equation for F by observing
that it implies
r r f T
r f T
e F E e Q T e E e
Q T e Q 0
which gives the T -forward (domestic per unit of foreign) exchange rate
rT
rT
r f T
F e
r r T
f
Q 0
The exchange rate from the foreign viewpoint is given by the stochastic differential equation (9.3.25)
1 1 f
f
f
2
r
dt
t
dW
t
t
1
t
dW
2
1
2
2 t
Q t Q t
Therefore,
r f r t
1
e
Q t
f
Q T
The left-hand side is the risk-neutral pricing formula applied to the derivative security that pays
in exchange for F f (both denominates in foreign currency) at time T . Setting this equal to zero
determines the forward price. We may solve this equation for F f by observing that it implies
f
f
f
1 rT f r f r T 1 rT 1
e r T F f E e r T
e E e
e
Q
T
Q
T
Q 0
which gives the T -forward (foreign per unit of foreign) exchange rate
r f r T 1 1
Ff e
Q 0 F
1
Q T
rT
E e Q T K
dQ t Q t r r f dt 2 dW3 t
from which we conclude that
Q T Q 0 exp 2 W3 T r r f 22 T
2
Define
Y
W3 T
T
so Y is a standard normal random variable under P . Then the price of the call is
E e rT Q T K
1 2
rT
f
E e Q 0 exp 2 TY r r 2 T K
2
This expression is just like (5.5.10) with T , with Q 0 in place of x, and with r f in place
E e rT Q T K e r T Q 0 N d e rT KN d
9.3.28
where
Q 0
1 2
f
log
2 T
K
2
2 T
and N is the cumulative standard normal distribution function. Equation (9.3.28) is calles the
Garman - Kohlhagen formula.
d
r
c t , x E e x exp Y r a 2 K
2
c t , x xe aT N d , x e rT KN d , x
(5.5.10)
(5.5.12)
Q 0
dP
f
f
1
f
D
T
M
T Q T d P for all A F
P A
A
Q
0
(9.3.17)
pays off
K units of foreign currency at expiration time T . The foreign
Q
T
currency value of this at time zero, which is the foreign risk-neutral expected value of
the discounted payoff, is
f
1
f
E D T
K
Q T
D T M f T Q T
1
f
E
D T
K
Q 0
Q T
E D T 1 KQ T
Q 0
K
1
E D T Q T
Q 0
K
K
This is the time-zero value in domestic currency of
puts on the foreign
Q 0
exchange rate. More specifically, a put struck at
1
on a unit of foreign
K
1
E D T Q T
K
K
The call we began with is worth
of these puts.
Q 0
1
The foreign currency price of the put struck at
on a unit of foreign currency is
K
1
1
E D T Q T
Q 0
K
The call we began with has a value K times this amount. When we denominate
both the call and the put this way in foreign currency, we can then understand the
final result. Indeed, we have seen that the option to exchange K units of foreign
currency for one unit of domestic currency (the call) is the same as K option to
1
exchange
units of domestic currency for one unit of foreign currency (the put).
K
Stated in this way, the result is almost obvius.