A risk control tool for foreign financial activities - A new derivatives pricing model

Abstract

Investors as well as firms are concerned with not only foreign/domestic stock price risk but also foreign exchange rate risk when making decisions for investing (or financing) overseas. In this paper, a new contingent claim is proposed for the derivatives markets for use in the domestic or foreign derivatives markets. Particularly, we address hedging against stock and exchange rate risk while adjusting for protecting the value of a collateralized stock. We introduce a closed-form solution for a Quanto put option coupled with a reset feature to hedge against downside risk while maintain upside potential from foreign investments. The Quanto options meet the investors' concerns for exchange rate risk while the reset feature locks in value against downside stock risk. The proposed product is an efficient tool for risk management and aims to support decision making for firms when considering financing and investing in the foreign markets. © 2016 Macmillan Publishers Ltd.