MISSPECIFICATION AND THE PRICING AND HEDGING OF LONG-TERM FOREIGN-CURRENCY OPTIONS

This study examines the effects of stochastic volatility upon the pricing and hedging of long-term foreign currency options. The traditional method of pricing such options uses a constant volatility option model with an implicit volatility derived from a short-term traded option. We show that the traditional method leads to small pricing errors for short- and medium-term options, but does a poor job in pricing long-term options. The traditional method also does a poor job for all maturities in determining the derivatives of the option's value with respect to the exchange rate (delta) and the volatility (vega). The errors in calculating these derivatives, which are used in forming the replicating portfolio, lead to large and costly errors in error hedging.