Foreign Exchange Derivative Pricing with Stochastic Correlation

Abstract

Financial markets are known to be far from deterministic but stochastic and hence time dependent correlation tends to suit the markets. We price for European Options by using three dimensional assets under stochastic correlation. The pricing equations under constant correlation and stochastic correlation are derived numerically by using finite difference method called the Crank Nicolson method. We compare the pricing equations when the correlation is stochastic and constant by using real data from emerging financial markets, that is, exchange rates data for Kenya as the domestic currency and South Africa as the foreign currency. Pricing equation for the European option with stochastic correlation performed better than that with constant correlation.