Pricing currency derivatives with Markov-modulated Lévy dynamics (Q2513442)

The paper provides a generalization of some results in [\textit{L. Bo} et al., ibid. 46, No. 3, 461--469 (2010; Zbl 1231.91425)] to the case when the dynamics of the FX rate is driven by a Markov modulated Lévy process. Using a Lévy process, the authors employ the Esscher transform parameters for the log-normal distribution, ensuring that the martingale condition holds for the discounted foreign exchange rate. Based on these values of the parameters, they find a risk-neural measure, and provided new formulae for the distribution of jumps, the mean jump size, and the Poisson process intensity with respect to this measure. Pricing formulae for a European call foreign exchange option are also derived. These formulae are similar to the ones obtained in Bo's paper, the differences being in the mean jump size and in the process intensity. Numerical simulations for the prices of a European call foreign exchange option for various parameters are provided. In the numerical simulations, they assume that the hidden Markov chain has three states: up, down, side-way. The corresponding rate matrix is calculated using real FOREX data for a thirteen-year period. The jump distributions considered here are the log-double exponential and the exponential. The Matlab codes for simulations are provided in the Appendix.