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Risk free rate in stochastic volatility model for FX options

  • Thread starter Thread starter Aber
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Aber

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When dealing with FX options. Can anyone suggest some paper on how to set the risk free rate?

For instance: Let's assume I want to price a call option with underlying being a EURUSD forward and the forward follows Heston dynamics. What will my risk Neutral dynamics be?
 
In currency land you can choose to price your derivative under the domestic or foreign risk neutral measure (Domestic := right-hand currency (USD), while foreign := left-hand currency (EUR)). A priori, there is no reason why you should prefer one over the other.
Generally said measures are non-equivalent.

For a reasonable introduction to the field, see Bjork, ch. 17, Arbitrage Theory in Continuous Time.
 

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