1 Pricing Multivariate Currency Options with Copulas

INTRODUCTION Multivariate options are widely used when there is a need to hedge against a number of risks simultaneously; such as when there is an exposure to several currencies or the need to provide cover against an index such as the FTSE100, or indeed any portfolio of assets. In the case of a basket option the payoff depends on the value of the entire portfolio or basket of assets where the basket is some weighted average of the underlying assets. The principal reason for using basket options is that they are cheaper to use for portfolio insurance than a corresponding portfolio of plain vanilla options on the individual assets. This cost saving depends on the correlation structure between the assets; the lower the correlation between currency pairs in a currency portfolio for instance, the greater the cost saving. However, the accurate pricing of basket options is a non-trivial task when, as is generally the case, there is no accurate analytic expression of the distribution of the weighted sum of the underlying assets in the basket. Apart from using Monte Carlo methods, basket options are often priced by assuming the basket or index is a single underlying and then applying standard option pricing theory based on the Black-Scholes (1973) framework. However, a weighted sum of log-normals is not itself log-normally distributed and potentially significant errors are introduced through this approximation by ignoring the distributional characteristics of the individual underlying assets