Foreign Exchange Markets

Abstract

This chapter covers several topics relevant for the foreign exchange (FX) derivatives market, including the traders' rule of thumb to price exotics with vanna and volga, issues on systems, bid-ask spreads, and a glossary and some hopefully useful summary tables. Vanna-volga pricing is a traders' rule of thumb to determine the cost of risk managing the volatility risk of exotic options with vanilla options. This cost is then added to the theoretical value in the Black-Scholes model and is called the overhedge. There are many pricing and risk management systems and tools. However, there are not many vendor systems with a dedicated focus on FX. A risk management system with a dedicated FX focus is FENICS. For pricing across a wide range of exotics, SuperDerivatives is widely spread among banks as well as the buy-side. Both use proprietary models for their vanilla volatility surface construction and exotics pricing.