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Heston Model Calibration in the Brazilian Foreign Exchange (FX) Options Market

Author

Listed:
  • Marcelo Nóbrega da Costa

    (Dresdner Bank do Brasil)

  • Joe Akira Yoshino

    () (Departamento de Economia, FEA, USP)

Abstract

Despite the relatively recent advance in the derivative industry, the European FX option market uses simple models such as Black (1976) or Garman and Kohlhagen (1983). This widespread practice hides very important quantitative effects that could be better explored by using alternative pricing models such as the one that incorporates the stochastic volatility features. Understanding and calibrating this type of pricing model represents a challenge in the current state of art in financial engineering, specially in emerging markets that are characterized by strong volatilities, periodic changing regimes and in most case suffering of liquidity, specially during the crisis. In this sense, this paper shows how to implement the Hestons Model for the Brazilian FX option market. This approach uses the volatility matrix provided by a pool of domestic market players. Although the Hestons Model presents a formal analytical solution it does not require simulation-, the closed form solutions show a mathematical complexity. Thus, the main objective of this work is to implement this model in the Brazilian FX market.

Suggested Citation

  • Marcelo Nóbrega da Costa & Joe Akira Yoshino, 2004. "Heston Model Calibration in the Brazilian Foreign Exchange (FX) Options Market," Brazilian Review of Finance, Brazilian Society of Finance, vol. 2(1), pages 23-46.
  • Handle: RePEc:brf:journl:v:2:y:2004:i:1:p:23-46
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    More about this item

    Keywords

    Heston's model; stochastic volatility; FX derivatives;

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • C36 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Instrumental Variables (IV) Estimation
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems

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