Hello everybody,I am currently writing a empirical research thesis (Bachelor level - nothing too complicated) on the pricing of discount certificates on futures. For all products the underlying is denominated in a different currency than the products. Some of the products are quanto, some are not. Basically to price the product I have to use either a quanto or cross option. I am using data for the options from www.euwax.de . As for some products I have to caclulate the option price myself, I am especially wondering what I should do with correlation. Can I use historical correlation between the 2 FXs or is there an "implicit correlation"? Any help is highly appreciated....Cheers Donut

I don't entirely understand what your product is. If it is just FX, correlations are determined by the volatilities, and they are implicit in option prices - look here for example.Otherwise, you will find that your hedging strategies generate different P&Ls for different correlations - meaning that you will be taking a position on correlation. "Long correlation position" means your position is such that you will be positive if correlation is higher than your guess, and "short correlation" means you will be positive if it is lower. It is no different from buying a stock - you make money if it goes up, lose money if it goes down.Banks and hedge funds trade many correlation products, and the idea is that you put several such products on your books in such a way that your position on correlation (and other abstract quantities) balances itself out and is on the whole neutral. However these products are not exchange traded, and it may be difficult to obtain broker quotes on correlation - however you can try. A broker quote is the price at which you can buy or sell correlation on the market to balance your own position, and that would be the number you would put in - because that is the price at which you can eliminate all risk from your portfolio. If you can't obtain broker quotes, you need to understand how your position depends on the correlation and what your sensitivity is; in other words, if correlaton goes up by a basis point, does your P&L go up or down? By how much? Once you know that, you would take a bet on correlation; say, "it was 11% over the last year, so I am happy to bet it is between 5% and 15% next year". Then you would set the bid-offer spread (difference between what you sell and buy the product for) to cover this range, and make you some commission.Hope this helps.

Hi first of all thanks for the reply,I know about vol/correl products, but this is not what I am really focusing on. Just to elaborate about the product and my thesis:The product is "normal" discount certificate (DC) - similar to a reverse convertible - that you can duplicate via short put on the underlying and riskless asset or long position in the underlying and short call. Wohlwend or Wilkens have already done a couple of papers to compare the fair value of discount certificates via the duplication strategy with the price of the issuer for the Swiss and German market. As the research has focused so far on stocks, I want to do a similar empirical analysis on discount certificates on commodities-futures. For stocks as underlying the replication is straiaht fgrward .... the replication for commodities is a bit more complicated. As the underlyings are mainly in USD, but the DC itself is denominated in EUR, you use-quanto option if you want no FX risk for the product, -cross option if you want FX risk for the productMy problem is, because there are mostly no exchange traded options available that fulfil all the criterias I need (strike, maturity, style - quanto/cross), I have to model the price of the option by myself. There is no problem to extract the implicit volatility, etc... from a similar option. However to price the a quanto-/cross option you also have to take account the correlation between EUR and USD. My question is what kind of correlation you use in order to price quanto-/cross-option? Can I basically just use the 1Y historical correlation or do I have to use "implicit correlation" (if it exists)? If I have to use "implicit correlation" how do I get it?

you can pull the implied correlation out of quanto forwards if you plug in spot, quoted forward and fx and underlying volatility:F=S*exp((r_foreign-divyield-sigma_udl*sigma_fx*corr_fx_udl)*T)

Thanks, I will give it a try