Chapter 5. FX Derivatives

FX derivatives (or foreign exchange derivatives) are financial derivative products whose payoff is a function of the exchange rate of two (or more) currencies. Like derivatives in general, FX derivatives can be grouped in three main categories: futures, swaps, and options. In this chapter, we will only deal with option-type derivatives. We will start with a straightforward generalization of the basic Black-Scholes model, and will show how to price a simple European call or put currency option. Afterwards, we will discuss the pricing of exchange options and quanto options.

Throughout this chapter, we will assume that you have some basic knowledge about derivative pricing, especially the Black-Scholes model and risk-neutral valuation. Occasionally, we will refer to some mathematic relationships often used in quantitative finance (such as Itô's lemma or Girsanov theorem), but a deep understanding of these theorems is not essential for this chapter. However, those interested...