Pricing model
New to option pricing? Start with Understanding option pricing. The full methodology, with every formula and its references, is in Pricing methodology.
Every quote starts from a fair price calculated by BlockFinaX's pricing engine. The pool then applies its own markup. This page explains how the fair price is found.
What is being priced
A protection contract pays nothing below the strike, pays more as the rate moves past the strike, and stops growing at the limit. In option terms it is a spread: an Up cover is a call spread, a Down cover a put spread. The engine prices it as the difference between two options, one at the strike and one at the limit.
The model, in three layers
1. Currency option pricing. The base is the Garman-Kohlhagen model, the standard way to value options on a currency pair. It uses today's rate, the strike, the time to expiry, interest rates and volatility.
It values the contract from today's rate, the strike, the time to expiry, interest rates and volatility. The formula and how it works are in the developer Pricing methodology.
2. Sudden moves. Emerging-market currencies often jump on devaluations and policy changes rather than drifting smoothly. The engine adds Merton jump diffusion, which mixes ordinary movement with occasional jumps, with a frequency and size set for the pair's market type.
3. Changing volatility. Volatility today is not volatility for the whole contract. The engine uses a GARCH model to estimate the average volatility expected over the contract's life, pulling today's level toward the pair's long-run level.
Inputs
| Input | Source | Effect on price |
|---|---|---|
| Today's rate (S) | The protocol's market data feed | Sets how far the strike and limit are from today |
| Strike (K) and limit | Your request | A strike nearer today's rate, or a wider limit, costs more |
| Time to expiry (T) | Your tenor, counted to the second from when you buy until the end time | Longer costs more, so a short contract bought earlier in the day costs slightly more |
| Volatility (σ) | 60 days of daily moves, weighted toward recent days, raised by a risk margin for the pair's market type, with a minimum level | Higher volatility costs more |
| Long-run volatility and persistence | The pair's five-year daily history; persistence is fitted for the pair, or a default for its market type | Sets how quickly today's volatility fades |
| Jump frequency and size | Settings for the pair's market type, calibrated on that group's history (can be set for a single pair) | More and larger jumps cost more |
| US interest rate (r) | US Treasury rate | Small effect |
| Long-term trend | The pair's average yearly change over five years, limited to 50% a year | A currency that has weakened steadily makes an Up cover cost more |
Risk margins and minimums by market type
| Market type | Margin added to measured volatility | Minimum volatility |
|---|---|---|
| Major currencies | 12.5% | 5% |
| Major emerging markets | 25% | 5% |
| Less liquid emerging markets | 40% | 5% |
| Frontier markets (for example NGN, GHS, KES) | 75% | 15% |
| Pegged or managed currencies | 150% | 30% |
Safeguards
The engine refuses to price a contract when:
- its maximum payout would be more than 100 times its premium (too cheap for the risk, usually when volatility is at its minimum);
- its maximum payout would be less than 1.5 times its premium (too expensive to be worth buying);
- the pair's price history is out of date.
From fair price to your price
The fair price is a rate per dollar of notional. The pool you buy from multiplies it by its markup for your tenor. See Premium calculation.