Validation plan of FX Vanilla Option Pricing models

Long time back I validated FX Vanilla Option Pricing model. I would like to present some suggestions on it’s validation.

The validation plan of FX vanilla option pricing model can be divided into following parts:

  1. Data validation
  2. Conceptual soundness
  3. Outcomes analysis
  4. Ongoing monitoring

Data validation will involve:

  1. Check of data consistency between current source, risk systems, front office pricing systems.
  2. Checking if the right interest rate curves, volatility surfaces are used. It was once observed that because of lack of volatility surface information, the model owners used the surfaces of an alternate currency. If such decision has been made, then then the rationale should be document.
  3. Check of FX spot rates and forward rates.

Here we will have to choose a set of currency pairs on which validation should primarily focus, these choices should include:

  1. Currencies pairs which are adequately liquid
  2. Currency pairs that are major part of the portfolio
  3. Currency pairs which have currencies whose exchange rates are available only with indirect quotes
  4. There should be at least one currency pair that is not adequately liquid, so that the illiquidity impact may be studied.

Conceptual Soundness can be checked by the following steps:

  1. The first step should be the external replication of all the following:
    1. Pricing of the options
    2. Calculation of the sensitivities
    3. Calculation of the volatility surfaces
    4. Construction of the interest rate curves and interpolation methodologies
    5. If the risk system has to be validated then the VaR calculations must be replicated.
  2. The external replication should be compared with all possible borderline cases of all the variables and their possible combinations.
  3. The second part should be exploring the possibilities of benchmarking the currently used methodologies for pricing, interpolation, volatility curve constructions by
    1. External sources: Usage of those sources should be justified by the validator.
    2. Alternate methodologies: Again, same as above
    3. The results should be used either to challenge the model output or support the model output.
  4. If Garman–Kohlhagen pricing formula is used then the data assumptions should be checked by studying the historical data.
    1. This formula assumes that the spot rates are lognormally distributed, this should be checked by studying the historical data.
    2. The consistency and inconsistencies of interest rate party using historical data should be checked.

Outcomes Analysis: A report should be developed where it should be discussed that which currency pairs demonstrate consistencies in above the properties mentioned.

Ongoing Monitoring

The ongoing monitoring report should document the periodic model performance compared with the external data and realized trades. The monitoring report should also document the data deviations and their impact.

 

Dear reader, first of all thank you for visiting this page! In case you think that the validation can be improved then please leave a suggestion, I will include your suggestion with acknowledgment.

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