The pricing of Quanto options under dynamic correlation

The Quanto option is a cash-settled, cross-currency derivative in which the underlying asset has a payoff in one country, but the payoff is converted to another currency in which the option is settled. Thus, the correlation between the underlying asset and currency exchange rate plays an important role on pricing such options. Market observations give clear evidence that financial quantities are correlated in a strongly nonlinear, non-deterministic way. In this work, instead of assuming a constant correlation, we develop a strategy for pricing the Quanto option under dynamic correlation in a closed formula, including the calibration to market data. By comparing the pricing and hedging strategy with and without dynamic correlation, we study the effect of dynamic correlation on the option pricing and hedging. The numerical results show that the prices of Quanto option under dynamic correlation can be better fitted to the market prices than using simply a constant correlation.