Quanto option pricing in the presence of fat tails and asymmetric dependence

We present an approach to pricing European quanto options assuming that the underlying instruments follow a multivariate normal tempered stable (NTS) process. This allows for both fat-tailedness and asymmetric dependence between the returns on the underlying asset and the exchange rate. In an empirical application, we estimate the market and risk-neutral parameters for a quanto construction involving the Nikkei 225 index, as the underlying asset, and the Japanese yen and the US dollar exchange rate. While the Gaussian model is clearly rejected by the data, the NTS model cannot be rejected at any reasonable level. A calibration exercise demonstrates that the prices implied by the estimated NTS and the conventional Gaussian models differ substantially, with the NTS model yielding a superior performance as it better reflects the tail properties of the instruments involved.