Econometric Identification of Foreign Exchange Options Volatility Surfaces Recovering Foreign Exchange Option Prices from Spot Price Dynamics

Over-the-counter foreign exchange options (OTC-FXOs) are the fourth largest derivatives market in the world. However, the extant literature on their pricing is noticeably thin. We propose a new discrete time exponential-affine multi-factor model, with multiple estimation strategies and pricing confidence intervals for the resulting synthetic volatility surface, for OTC-FXOs and test the various specifications out-of-sample on five liquid currencies versus the dollar. Our specification is the first of its type that can be estimated directly from spot FX and deposit rate quotes without recourse to quoted volatility surfaces. Results indicate that both short and long tenor OTC-FXOs can be accurately priced with minimal calibration