Will take your example - so for EUR/USD and USD/INR, for which IVs are available in the corresponding market, the IVs for EUR/INR can be derived by pricing in the correlation between the spots (forwards to be precise) while treating this as a two-asset portfolio.Of course, the key is to plug in the "correct" correlation number. You can get a feel of the future correlation by looking at the historical correlation for different time horizons, of course at your own risk - of believing that history will repeat itself.Hope that helps.Cheers

I don't know if it is actually used in the market, but you can try to use Breeden and Litzenberger to determine the cross currency CDF for the illiquid pair, and thereby price the option. At university I wrote a paper investigating this problem in the context of pricing cross-currency forward options. It wasn't very advanced work though.

Not much help to you there...Unless an assumption of independence would be appropriate...? That would depend on the currencies in question. If not, you're stuck with either the historic correlation.

Not much help to you there...Unless an assumption of independence would be appropriate...? That would depend on the currencies in question. If not, you're stuck with the historic correlation.

Yup that's me. Not a brilliant paper becuz of the simplifying assumptions...like independence.

suppose you can observe the ATM vol in the market you can then compute the implied correlationis there any way from there, and from the smiles of the 2 major ccypairs, to imply the vol smile of the cross ccy?anybody has worked on that?

i think Anup is talking about INR/EUR options. Recently there have been querries on this. There are ways to hedge the exposure using USD/INR options and USD/EUR options. Have you heard of geometry of vols? I am not sure about the exact structure. Using both because spot moves a lot when INR guys are sleeping (EUR jumps around like a crazy,drunk man,perfect example for random walk on any given day/night!). regardscosmo

There is paper by Uwe Wystup on this subject about geometrical relationship that has been mentioned. CheersJugal

QuoteOriginally posted by: anupkurupthe root of the problem is that there are no options traded in the market.so ATM vols cannot be observed.i'll try to tackle the smile problem once i'm thru with simple ATM iv.anyone knows how it's done in the big ib firms?actually there are a lot of ccy pairs where you do know the ATM vol but not the risky and fly.not emk ccys, but stuff like chfjpy, euraud, audnzd, etc...ATM trades in the brokers, but nobody wants to quote a price on 25 delta optionsi know one IB has a model for that, but im not expecting the code on this boardjust some ideas, if anybody has got someif you dont have the ATM vol, the only way to get an idea is to look at historic data.if you assume correl is more stable than vol, take historical correl, and imply the vol through the triaangular relationship.but historically, the correl is not always more stable than the vol

What about the liquid triangles, like EUR\USD\JPY ?In that case we got three smiles really, but i do not know any arbitrage bounds on the smile. Apart of course from the triangle inequality, usually involving the ZD by the way, whereas the variances of spot would seem more natural to me...and yet I have not seen a real arb (finite time, no BS model) described anywhere. The market seems to enforce the ZD however. Unfortunately I don't know any way to make money from an overarbitraged market...

there are several article on the pricing of illiquid currency. To resume, the first step is to interpolate the two smile and the second step is to use a copula model to price your illiquid currency