QUANTO

MECHANICS
Investorsand dealersare increasinglyturning to equity-
linked forex options- then finding they don't know how
to value them. Eric Reinerexplains how to adapt
Black-Scholesand its variants

In a 1973 paper,1 Fischer Black and Myron Scholes showed that options on
equities could be valued through an ingenious dynamic hedging argument: an
option writer could, in theory, exactly offset his exposure to the underlying asset
by continuously buying or selling shares of stock. Since the overall hedge ratio
and, consequently, the net risk of his portfolio are always zero, the value of his
holdings must appreciate at the risk-free interest rate.
This observation leads naturally to the risk-neutral pricing principle of John
Cox and Stephen Ross:2 derivative assets may be valued as if the underlying
stock's mean rate of growth were equal to the riskless rate. In particular, the
value of a European option is simply the discounted present value of the pay-
off under the risk-adjusted probability distribution for the stock price at expiry.
Assuming that the instantaneous standard deviation of a stock's returns is
proportional to its price so that the risk-neutral density is lognormal, Black and
Scholes found the value of a call with pay-off

C* = max[ S* - K, 0 ]

to be:3

with

1 Black and Scholes (1973)

2 Cox and Ross (1976) ; see also
Garman (1976)
3 This article follows the notation

In these expressions, S is the spot price of the underlying asset, t is the time used in Cox and Rubinstein
(19B5). The formula as written
to expiration of the option, K is the strike price, r is one plus the rate of interest, here includes the modification for
pay-outs derived by Merton
d is one plus the proportional pay-out rate of the underlying asset, crsis the (1973) . In that article , Merton
stock price volatility, and N( ·) is the standard normal distribution function. The also showed that the Black-
Scholes equation could be
value of a put may be obtained by negating the arguments of the normal functions extended to allow r, d and a, to
and then negating the entire expression for C.The option writer's hedge portfolio be known functions of time. For
simplicity, these parameters are
consists of assumed constant here. The
values of all random variables at
option expiry will be indicated by
a superscript* and foreign-
denominated values will be
denoted by a prime (')
• To simplify the discussion, this
article will assume that option
shares of stock4 and a (short) cash position of writers hedge in the spot market
and that they borrow and lend
both domestic and foreign cash
B= -Kr-tN(x-crs.Jt) at the corresponding riskless
rates 147
 RISK/FINEX

In a foreign exchange context, Mark Garman and Steven Kohlhagen 5 showed

that much the same arguments may be applied to value options on currencies,
but with the foreign interest rate replacing the dividend yield. Their formula
for the value of a call on a foreign currency with pay-off

C* = max[ X* - K, 0 ]

lS:

with

Here, X is the spot exchange rate expressed as the price in domestic currency
of a unit of foreign currency, rt is one plus the foreign riskless rate, and crxis
the exchange rate volatility. The corresponding hedge portfolio is

B' = rf1 N(y)

units of foreign currency and

in domestic cash. Note that these expressions are identical to those obtained
by Black and Scholes in an equity setting, but with rt replacing d and crx
replacing CJ5 •
In a global equity market it is possible to link foreign stock and currency
exposures in a variety of interesting ways: investors may choose to combine their
investments in foreign equities with differing degrees of protection against
adverse moves in exchange rates, equity prices, or combinations thereof. Four
scenarios, in roughly increasing order of complexity, and the pay-offs that match
them are:

1. An investor wants to participate in gains in a foreign equity, desires protection

against losses in that equity, but is unconcerned about the translation risk arising
from a potential drop in the exchange rate. Such an investor might desire the
pay-off of a foreign equity call struck in foreign currency:

C1* = X* max[S'* - K', 0 J

where S'* is the equity price in its own currency after time t and K' is a foreign
currency amount . In this formula, X* appears in front of the maximum function,
indicating that the final pay-off must be converted into domestic currency.

2. An investor wishes to receive any positive returns from the foreign market,
• Garman and Kohlhagen (1983)
6 Pay-offs 1 and 2 are two of but wants to be certain that those returns are meaningful when translated back
the four possible cal I pay-off s into his own currency. For him, it is the product of the foreign asset price and
combining a foreign or domestic
strike price. The remaining two the exchange rate at expiry that is important, and he might be interested in a
are max[S* - K,01 (domesti c
equity/domestic strike) and pay-off like that of a foreign equity call struck in domestic currency:
max[S* - K'X*,OJ (domestic
equity/foreign strike). The first of
these is just the pay-off C2 * = max[ S'*X* - K, 0]
corresponding to the Black-
Scholes formula. We will obtain a
valuation formula for the second where K is now a domestic currency amount and X* multiplies S'* only,
(in a slightly disguised form) in
148 the course of valuing pay-off 2 representing tran slation of the foreign equity value into domestic terms. 6
FROMBLACK-SCHOLES
TO BLACKHOLES

3. An investor wants, as in the first scenario, to capture upside returns on his

foreign investment, but now desires to hedge away all exchange risk by fixing
in advance a rate at which the pay-off will be converted into domestic currency,
effectivelylinking a foreign equity option with a currency forward. This investor's
desired pay-off pattern is that of afixed exchangerateforeign equity call,also known
as a Qyanto: 7
C3 * = Xmax[S'*-K',O] = max[S'* X-K,o]

where X is the rate at which the translation will be made and the two equivalent
forms of the pay-off arise from the choice of expressing the strike in foreign
or domestic terms.

4. An investor desires foreign equity exposure regardless of whether the stock

market rises or falls, but wishes to place a floor on the exchange component
of his investment. This strategy, which combines a currency option with an equity
forward to create a variable quantity forex option called an equity-linkedforeign
exchangecall,8 is the complement to the contract in scenario 3, and has the pay-
off:

C/ = S'* max[ X* - K, 0 1

Since the pay-offs of each of these options resemble closely those of simple
equity and currency calls, and since the products of the (risk-neutral) lognormal
variables which appear in these pay-offs are also lognormally distributed, it is
not surprising that closed-form valuation formulae quite similar to the Black-
Scholes equation may be derived for each contract. What is remarkable, some-
times even counter-intuitive, is the way that market parameters, interest and
dividend rates, volatilities, and the correlation between the equity and currency
markets appear in some of these formulae. The remainder of this article shows
how these valuation results may be obtained. 9
The first case, that of a foreign equity call with strike K' also in foreign
currency, is particularly simple. The necessary observation is that X* plays an
almost trivial role in the pay-off: whatever payment in the foreign currency results
from exercise of the option is just converted at the spot exchange rate at expiry.
To make use of this point, consider an option writer located in the country
where S' is traded . She is indifferent (in a frictionless market) between this call
paying off in your currency and a simple option on S' paying off in her own.
Accordingly, the present value in foreign units of the call is just given by the
Black-Scholes formula. To obtain the domestic currency value of the option
we need only invoke the law of one price, which requires that identical contrac~
have equivalent prices in all markets, to find (by multiplying by the spot exchange
rate):
7 These options were discussed
briefly in Rubinstein (1991)
8 Or, as it is called by Bankers
Trust, which currently offers such
contracts, Elf-X. Analogous
contracts were originally
with discussed by Marcus and Modest
O9B6)
9 In each of Ci* to C,*, the
components of the pay-off must
be chosen so that th e units of
payment are consistent. For
example, to a US investor with
an underlying British equity
exposure these pay-offs are:
C, * ($/share) = X* ($/£) max [S'*
where <Jsis the volatility of S'. This argument also allows us to identify easily (£/share) - K' (£/share), OJ,
the hedge portfolio as: C, * ($/share) = max [S'* (£/
share) X* ($/£ ) - K ($/share), OJ,
C3* ($/share ) = X ($/£ ) max
[S'* (£/share) - K' (£/share), OJ,
and C,* ($/share) = S'* (£/share)
max [X* ($/£ ) - K ($/£ ), OJ 149
 RISK/FINEX

shares of stock and

units of foreign cash, identical to the holdings of the foreign-based option writer.
A very similar line of reasoning may be used to value the second type of
foreign equity call, which is struck in domestic currency. Again we may adopt
the viewpoint of the foreign-based option writer. To her, the pay-off looks like:

C/* = max[ S'* - KX'*, 0 J

where X = 1/X is the exchange rate quoted at the price of a unit of (our) domestic
currency in terms of her (our foreign) currency. But this is merely the pay-off
of an option to exchange one asset (K units of our currency) for another (a share
of stock), and she may easily find 10 that this contract is worth:

c;* = S'd-tN(x 2 )-KX'r-tN(x 2 - crs'x'.Jt),

with

log(S' d-t / KX'r-t) ~

_ ----~-- (Js'x' ...;t
X2 = ~ +
<Js'x' v t 2

and

Here, <Jx'= <Jx,<Js'xis the relative volatility of S' and X', and Ps'x'is the correlation
between the rate of return of S' and that of X'. Again, we may multiply by the
exchange rate and replace X' everywhere by 1/X to obtain the domestic value
of this option. Only one step requires care: the rate of return for X' is exactly
the negative of that for X, so that the correlation coefficient Ps'xbetween S' and
X is equal to -ps 'x'· The final valuation formula is:

C2 = S'Xd-tN(x 2 )-Kr-tN(x 2 - crs'x.Ji),

with

log( S'Xd-t / Kr-t) er , .Jt

X2 = ----=---+-s_x _
(Js'x.Jt 2

and

Note that the differences between the arguments of the normal distribution
functions are notational only, and are introduced purely for convenience. This
contract may be hedged with a position of

units of stock and

10 Valuation of this pay-off is a
straightforward application of the
theory developed by Margrabe
(1978) and extended by Mark
150 Rubinstein (see Chapter 29) in domestic cash.
FROMBLACK-SCHOLES
TO BLACKHOLES

Before proceeding to the more complicated valuation results for options 3

and 4, it is useful to study the formulae we have obtained for the simpler cases
above. In particular, the results for option 2 are quite revealing. S' and X always
appear together as a product in these expressions, replacing Sin the Black-Scholes
equation just as the product volatility Cf5,xreplaces cr,. Further, the foreign interest
rate shows up nowhere, while the currency-translated stock price is discounted
by d-t only. Similarly, there is no foreign cash position in the hedge portfolio.
It is as if the product S'X were itself a domestically traded equity with volatility
Cf5,xand a proportional pay-out rate of d-1 and we could apply the risk-neutral
pricing approach to value derivative assets on S'X as an underlying stock.
This is a consequence of Mark Garman's relativity principle: the laws of
finance are the same in all frames of reference, so that assets are valued identically
in all markets. To see these results more directly, we can use the following
argument. Suppose that the foreign equity were also traded domestically. Then,
to preclude arbitrage, its price could only be S'X and its volatility would be that
of the product of S' and X, namely crs'x· Further, the proportional pay-out rate
d-1 would be identical in both markets. We could then apply Black and Scholes'
hedging argument to derive the result for C2 given above.
The foregoing analysis allows us to develop two parallel sets of simple rules
for valuing pay-offs like C1* - C4 * in a Black-Scholes setting: the domestic
market method and the foreign market method.

DOMESTICMARKETMETHOD
1. Replace S'* by (S'X)*/X* everywhere in the pay-off function to express it
in terms of the hypothetical domestically traded asset S'X.
2. Value the resulting pay-off under the risk-adjusted joint probability distri-
bution for (S'X)* and X*, where S'X and X have yield rates d-1 and rf-1,
volatilities Cf5,x and cr., and correlation Ps·x,x = (cr5,p5,x + crx)/cJ
5,x.
11

3. Discount the pay-off at the domestic interest rate r-1 to obtain C, the present
value of the option.
4. Evaluate the hedge ratio .15, and foreign cash position B' by taking partial
derivatives of C with respect to S'X and X, respectively. Determine the domestic
cash position from:

B = C - ~S'X - B'X

FOREIGNMARKETMETHOD
1. Divide the pay- off by X* and substitute X* = 1/X'* everywhere to express
it in terms of the reciprocal exchange rate X'.
2. Value the resulting pay-off under the risk-adjusted joint probability distri-
bution for S'* and X'*, where S' and X' have yield rates d-1 and r-1, volatilities
crs, and cr., = cr., and correlation Ps·x' = -Ps ·x·
3. Discount the pay-off at the foreign interest rate rf-1 to obtain C', the pre sent
value of the option, in foreign currency terms.
4. Evaluate the hedge ratio .1s' and domestic cash position B by taking partial
derivatives of C' with respect to S' and X', respectively. Determine the foreign
cash position from:

B' = C' - ~-S - BX'

5. Convert C' from foreign to dom estic units by multiplying by X and repla cing 11 Thi s peculiarformforthe
X' everywhere by 1/X. correlationcoefficient show s up
becauseS'X is a compos ite of
It is not too difficult to show that these procedures lead to identical results, the price processes forS' andX.
One canshowthatthe
but in practice it is often simpler to apply one rather than the other. For example, covarian ce of the returnrates of
the first option discussed here is most conveniently valued, as shown above, by S'X andX is o, (o,·p,·, + o,),
from whichtheexpressi on for
th e foreign market method. In contrast , valuation of the second pay-off is readily p,·..,followsdirectly 151
 RISK/FINEX

accomplished by the domestic market method.

Our remaining two options are best handled by the foreign market method.
To begin, pay-off 3 is rewritten in reciprocal units as:

C/* = XX'*max[S'*-K',o)

Next, we express this pay-off in the form

XX'ev max[S'eu-K',O]

where u and V are the natural logarithms of one plus the returns of S' and X'
respectively, and integrate its product with the risk-neutralised joint density for
U and v:

1
f(u,V)= ---.===--
2rt~l - Ps'x2 crs'crX t

with

and

µx, = log(r, / r)- cr} / 2

Note that the sign preceding 2p 5,, is positive for the reasons discussed earlier.
The region of integration may be restricted to log(K'/S') $ u < oo and -oo <
V < oo, and the quadrature with respect to V is readily performed to leave only
exponential functions in u. The final expression for the option value in foreign
currency becomes:

with

corresponding to a domestic value of:

The curious appearance of this formula is not all that is remarkable, though:
the hedge portfolio consists of

152
FROMBLACK-SCHOLES
TO BLACKHOLES

units of equity, B = C3 in domestic currency, and B' = -L\,S' in foreign cash!

How can we interpret these results? It is best to begin by understanding
the relationships between the hedge parameters. To a domestic option writer,
a position of,:\ , units of the foreign equity creates a proportional currency exposure
which must be exactly offset by B'. The net value of these holdings is zero, so
that the entirety of the call premium remains in cash. Alternatively, a foreign
writer of this contract carries exchange rate risk equal to the present value of
the option, which she must replicate with a forex exposure equal to C3 • Conse-
quently, she must borrow in her own currency the total amount necessary to
set up her hedge position in equity.
It is more interesting to explain the "discount factors" that appear before
each of the normal integrals in the formula for the option value and that are
combined in the expression for x3 • The second term in the formula represents
the exercise probability-weighted present value of having to pay out the strike
price, K'X. That this value is discounted at the domestic interest rate is not
surprising, since it is just a domestic cash amount. The term proportional to
the equity price presents a greater challenge to understanding. Let us first assume
that currency and stock price movements are uncorrelated. Then, to account
for the fact that the exchange rate is fixed, we must adjust the pay-off for S'
by a factor proportional to the accumulated interest rate differential over the
life of the option. This introduces the factor of (r/r 1)-t. But, if the exchange rate
and underlying equity are correlated, this adjustment is not sufficient. For
example, if the correlation is positive then increases in S' that raise the value
of the underlying equity option will be partly offset by increases in X that reduce
the value of the forex protection. This effect is accounted for by the exponential
factor, which just corrects for the correlation between the returns of S' and X.
The relevant volatility in x3 is just that of the underlying equity option,
namely <J5,.
It will be helpful in the analysis of our fourth pay-off to make use of the
following property: the symmetry arguments that make it possible to transform
the Black-Scholes formula for the value of a call into that of a put by changing
a few signs are equally applicable to each of the results derived above, as well
as to the formula we shall derive shortly for C4 •
To see this, consider what must be done to transform a call pay-off into
a put. First, the sign of the pay-off must be reversed, and this passes through
directly to the expression for the present value. Second, the limits for integration
over the log-return of one of the underlying assets must be changed from + 00

to the logarithm of the ratio of the strike to the present value of the asset (for
the upper limit) and from that logarithm to -oo for the lower limit. This has
the effect of negating the arguments of the normal distribution functions.
We can now utilise this property to value an equity-linked forex call. To
begin, express the pay-off in foreign terms as:

C4'* =S'* max[l - KX'*, O] = KS'* max[ 1/K - X'*, 01

In this form the underlying call reappears as a put, reflecting the fact that a
call on one currency struck in a second is equivalent to a put on the second
times a factor equal to the call strike. Our analysis can now be simplified if we
recognise that the present pay-off is in perfect analogy to that for a fixed exchange
rate foreign equity put for which we already have valuation results. We need
only exch_angeS' and X' (and their respective volatilities and pay-out rates) and
replace X by K and K' by 1/K to find a foreign market value of:

with 153
 RISK/FIN
EX

Optiontype Corresponding
parameters
Black-Scholes
(domesticequity) S K d a,
Garman-Kohlhagen (currency) X K r, a,
Foreignequity/foreignstrike S'X K'X r, d a,.
Foreignequity/domesticstrike S'X K d 0 s·i

rd
Fixedexchangerate foreignequity S'X K'X -exp(p.,,G,,G,) a,.
r,

Equity~inked
foreignexchange S'X KS' ~exp(p ,.,a,.a,) d a,
r,

corresponding to a domestic value of:

C4 = S'Xd- 1N(x4)-KS'(rd/r 1 t exp(-p 5,x<J5 ,<Jxt}N(x

4 -crx.Jt)

Here again, the hedge parameters take unusual forms. The net equity
exposure from this contract is just proportional to its value, so that ~s = C/
(S'X). The required foreign currency holdings may be found by differentiation
to equal

B' = KS'(rd) -t exp(-Ps'x<Js,<Jxt)N(x4

-crx.Jt)
X r1
which must be exactly offset by domestic cash, so that B = - B'X.
Each of the valuation formulas derived in this article may be obtained by
modifying one or more of the parameters in the Black-Scholes equation.
Consequently, our results may be concisely summarised by the table above.•

154