George Hong, head of the Asia-Pacific quantitative and risk strategies team at Credit Suisse, dialled in from his Hong Kong office to talk about his new paper on the valuation of quanto derivatives.
Quanto options gained popularity in the 90s as a way of taking a position on an asset without taking on its currency risk. The derivatives essentially allow an investor to take a position on a particular asset denominated in one currency, whereas the instrument itself is settled in another currency at a certain foreign exchange rate.
Despite financial institutions’ widening global footprint, and a corresponding increase in their forex risk management capabilities, quantos still remain a popular product in Asian markets. This is mainly because of the higher yields they can offer in a yield-starved environment, argues Hong.
“For example if the investor is bullish on Nikkei, but if the interest rate is too low on the Japanese yen, then by choosing a quanto derivative which has the payoff currency in, say, Australian dollars – which obviously has a much higher interest rate – one can get the best of both worlds compared to a non-quanto vanilla note which is yen-denominated,” said Hong.
However, the products aren’t easy to value. Back in the 1990s, in a constant volatility environment, a simple tweak to the drift term of the Black-Scholes model would have allowed one to value quanto options very easily. But today, with volatility skew, most valuation techniques can be quite cumbersome to compute and implement. Simple shortcuts might exist that can value the products quicker, but they lack accuracy.
Hong has developed a model that uses the so-called stochastic collocation method – a tool for quantifying uncertainty – to value quanto options. According to Hong, it is fast, more accurate and simpler to implement than existing techniques.
“The old ad hoc approach or implied approach, they were very successful because of a few things. They were very simple to understand; it was universal, it was very easy to implement and it was also very fast. What I am hoping to achieve is that this new method can retain all these advantages, but at the same time be much more accurate in capturing the volatility of skew,” said Hong.
The quant also said he will be doing more exploration into the use of stochastic collocation in his future research, and highlighted that more quant talent is needed in Asian markets because of the “quant drought” in Asia.
“There is a high demand and low supply of quants in the Asian markets. With a lot of exciting trends, say, for example, incorporating data science into quantitative finance, there is actually a lot of quant problems to solve here in Asia. It will be great if we can see more quants move to Asia,” said Hong.
1:03 Quanto options
1:30 Why are quanto options popular?
4:34 Difficulty in valuing quanto derivatives
7:28 Industry practices for valuing quantos
9:20 Simplified approaches
11:05 Introduction of the paper
13:14 Advantages of the new model
14:48 Challenges to implementation of new model
16:12 Future research
17:30 Problems to solve in Asian markets
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