
ADROptionTrading
at AOT
Problem
The problem AOT
presents is that of ADRoption pricing. In the brief outline below the
problem
and its setting is described. In the final presentation of the problem
a brief
introduction to options and option pricing will be given, such that the
jargon
will be clear.
ADRs
As a stock and
derivative trading firm AOT is active on several exchanges over the
world. One
of the strategies trading is based on, is the socalled ADR trading.
ADR is an
acronym for American Depository Receipt, and is a tradable on a US
exchange
that is based on a foreign stock. Consider for example the stock
ABNAMRO,
traded at Euronext Amsterdam. A U.S. bank bought a bunch of these
stocks, put
these into its safe and printed some U.S. notes that can be exchanged
for the
stocks. These notes are traded on the NYSE and called ABNAMROADRs. As
these
ADRS are equivalent with the ABNAMRO stock, their price should be the
price of
the Euronext listing converted into Dollars.
Options on ADRs
As the ADRs are traded
assets on an exchange, they can be used to construct derivatives. On a
lot of
ADRcounterparts of Dutch Euronext stocks options can be written or
bought.
ADROption trading consists of trading these U.S. options against the
Dutch
ones, and the hedging should  where
possible  be done with Dutch stocks (this reduces trading fees).
Pricing Problem
Before trading these
options, we need a price for them. Pricing the U.S. options comes at
this
moment down to correlation estimation between the Dutch stock and the
Euro/Dollar exchange rate, where we assume that both processes can be
modeled
by the standard GBM with correlated Brownian Motions. In the past this
did not
work well at all. Correlations are not stable, but heavily changing and
even
when they were stable the P/L did not match the expected P/L.
Furthermore it is
not clear at all how the correlation will translate Dutch skew into
U.S. skew.