20 views

Uploaded by Sam Sinha

Advanced Fixed Income Analytics

- IS-MCT-STA-L2.log
- Diary
- AirThread Case Questions - 2018
- Ge Mckinsey Matrix Powerpoint Presentation Slides
- Print
- q
- LIBOR tutorial - Feedback auf LinkedIn.pdf
- Annual Balance Sheet
- 02_Computing_Minimum_Edit_Distance_5-54.pdf
- Sales Sheet (1)
- Improve Performance of Fast Steady State Response for DC Servo Motor by Fuzzy Logic Implementation
- 12478
- Basic Parameter
- A.Row
- recommendation report st lm 2 last
- 2 1 Irwin/McGraw Hill
- lec37
- Ejemplos 2 y 3 Hechos en Clase Programacion Lineal
- IS-MCT-STA-L2.log
- English for Economic_chap2

You are on page 1of 13

Lecture 6

1. Uses of models

2. Assessment criteria

3. Assessment

4. Open questions and new directions

stochastic volatility (Cox-Ingersoll-Ross)

volatility inputs (Heath-Jarrow-Morton)

multiple factors

pricing kernels and risk-neutral probabilities

6-2

1. Use of Models

Valuation of new structures

{ approach 1: look at comparable assets in the market

{ approach 2: models guarantee consistency with other

(\even a bad model can be tuned to get some prices right")

{ what's the sensitivity to a 20 bp rise in 5-7 year spot rates?

{ models can be used to do \partial derivative" calculcations,

but the answer depends on the model

{ you take dierent short cuts depending on the purpose

{ the key is to understand where short cuts hurt you

2. Assessment

Questions for models:

{ does it reproduce current spot rates?

{ does it reproduce current term structure of volatility?

{ are sensitivities and hedge ratios reasonable?

{ does it reproduce swaption volatility matrix?

{ can volatility change randomly?

{ can it reproduce volatility smiles and skews?

{ does it allow \twists" in spot rate curve?

Summary assessment:

Ho-Lee Black-Derman-Toy Hull-White

spot rates?

yes

yes

yes

vol term str? no

yes

no

sensitivities? no

no?

maybe

vol matrix?

no

no

no

random vol? no

no

no

smiles?

no

no

no

twists?

no

no

no

6-3

2. Assessment (continued)

Ho and Lee

{ the innovation was to match current spot rates

{ didn't do the next step: volatilities

Black, Derman, and Toy

{ matches volatility term structure

{ short rate or log of short rate? (not clear)

Hull and White

{ but where does it hurt us?

{ technical trick: build mean reversion into trinomial tree

{ volatility matrix implied by models, not a exible input

{ no volatility smiles

{ one-factor structures

6-4

6-5

3. Vasicek Revisited

The model

, log m +1 = 2=2 + z + " +1

z +1 = (1 , ') + 'z + " +1

t

Pricing relation:

b +1 = E (m +1b +1)

n

Solution is log-linear:

, log b = A + B z

n

with

B +1 = 1 + B '

(start with A0 = B0 = 0)

n

Forward rates

{ denition is

f = log(b =b +1)

{ Vasicek solution is

f = ' z + constant

n

(think: Ho-Lee and BDT set ' = 1)

6-6

4. Stochastic Volatility

Cox-Ingersoll-Ross model

, log m +1 = (1 + 2=2)z + z 1 2" +1

z +1 = (1 , ') + 'z + z 1 2" +1

=

Comments:

{ conditional variance varies with z : Var z +1 = 2z

{ square root keeps z positive

{ mean reversion

t

, log b = A + B z

n

with

A +1 = A + B (1 , ') , ( + B )2 =2

B +1 = 1 + 2=2 + B ' , ( + B )2=2

(start with A0 = B0 = 0)

n

\stochastically"

6-7

Overview:

{ approach based on forward rates

{ allows input of volatility matrix

{ many variants | we focus on a linear one

Pricing relation for forward rates:

1 = E (m +1 R +1)

X ,1

log R +1 = r , (f +1

,f )

t

=1

Behavior of forward rates (we start to get specic here):

f +1,1 = f + + " +1

Comments:

{ note the volatility input : varies with date t and

maturity n (a matrix!)

{ linear structure common, not necessary

{ Vasicek is similar:

f +1,1 = f + constant + ' ,1" +1

(note the specic relation of volatility to maturity)

{ return is

X

X

log R +1 = r , , " +1

=1

=1

= r , A , S " +1

(A and S are partial sums)

{ other versions have multiple "'s

n

nt

nt

nt

jt

jt

nt

nt

6-8

Arbitrage-free pricing

{ a pricing kernel:

, log m +1 = + " +1

{ pricing relation imposes restrictions:

A , S , S 2 =2 = 0

t

nt

nt

nt

Calibration

{ inputs:

current forward rates: ff g

volatility matrix: f g

{ drift parameters f g chosen to satisfy arbitrage relation

{ open question: set = 0? (more shortly)

n

t

nt

n;t

nt

Implementation on trees

{ at each node we have complete forward rate curve

{ branches don't typically \recombine"

6-9

Approaches:

{ t smooth curve to observed implied volatilities

{ \implied binomial trees" that allow volatility to vary across

states as well as dates (see Chriss's book)

{ continuous models that extend Black-Scholes logic to

non-normal distributions

Gram-Charlier smiles

{ Gram-Charlier expansion adds terms for skewness ( 1) and

kurtosis ( 2) to the normal (where 1 = 2 = 0)

{ Wu's approximation of a volatility smile:

#

"

2

1

2

v = 1 , 3! d , 4! (1 , d )

where

2 =2

log(

F=K

)

+

v

d=

v

{ intuition:

positive skewness raises value of out-of-the-money calls

positive kurtosis raises probability of extreme events

and value of out-of-the-money puts and calls

6-10

7. Multi-Factor Models

Problems with one-factor models

{ changes in rates of all maturities tied to a single random

variable (")

{ shifts in spot rate curve come in only one type (parallel?)

{ correlation of spot rates across maturities restricted

{ spreads typically not variable enough

{ the model:

, log m +1 = + X(2=2 + z + "

t

it

+1

i;t

{ solution includes

= 'z + "

i

it

+1 )

j;t

+1

i;t

!2

X4 2

X

1

,

'

1

f = + 2 , + 1,' 5+ ' z :

{ standard solution: '1 close to one, '2 smaller )

z1 generates almost parallel shifts, z2 \twists"

long rates dominated by z1, spreads by z2

{ generates better behavior of spreads

n

i

it

6-11

We've taken two approaches to valuation

{ a pricing kernel (Vasicek, for example)

{ risk-neutral probabilities (binomial models)

How are they related?

{ q is value now of 1 dollar in down state next period

{ valuation of cash ows (c ; c ) follows

u

p = q c +q c

{ one-period discount factor is b = q + q = exp(,rh)

u

Risk-neutral probabilities

{ dene = q =(q + q ), = q =(q + q )

{ note: ( ; ) are positive and sum to one

u

(they're probabilities!)

{ valuation follows

p = exp(,rh)( c + c )

u

Pricing kernel

{ dene q = m , q = m (\true probabilities")

{ valuation follows

u

p = m c + m c

u

6-12

Where's the pricing kernel in a binomial model?

{ gure it out:

, log m +1 = + r + " +1;

t

with

2 = log( =) , log( =)

u

risk-neutral probabilities (and is zero when the two are

equal)

Is = 0 a mistake?

{ caveat: Black-Scholes pricing doesn't depend directly on

(so maybe it's not a bad mistake in general)

{ bottom line: who knows?

6-13

Summary

1. Models are

simplications of reality

ways to ensure consistency of pricing across assets

only as good s (and
oors) and swaptions

2. Binomial models capture some of the elements of observed asset

prices, but most versions leave some issues open:

stochastic volatility

volatility smiles (again, more work)

multiple factors (possible, just more work)

can we ignore ?

3. Modeling remains as much art as science

- IS-MCT-STA-L2.logUploaded byImroze
- DiaryUploaded byDominguez Ronald
- AirThread Case Questions - 2018Uploaded byshuai
- Ge Mckinsey Matrix Powerpoint Presentation SlidesUploaded byShahzad Waseem
- PrintUploaded byCarlos Teixeira
- qUploaded byMangal Gupta
- LIBOR tutorial - Feedback auf LinkedIn.pdfUploaded byadsingh
- Annual Balance SheetUploaded byAnton Wi
- 02_Computing_Minimum_Edit_Distance_5-54.pdfUploaded byAdvay Rajhansa
- Sales Sheet (1)Uploaded bybrainresolution
- Improve Performance of Fast Steady State Response for DC Servo Motor by Fuzzy Logic ImplementationUploaded byEditor IJRITCC
- 12478Uploaded byirqovi
- Basic ParameterUploaded byManish Chaturvedi
- A.RowUploaded byAnonymous 7S6P6SO5v
- recommendation report st lm 2 lastUploaded byapi-260824525
- 2 1 Irwin/McGraw HillUploaded bykemime
- lec37Uploaded byKhushboo Tewari
- Ejemplos 2 y 3 Hechos en Clase Programacion LinealUploaded byJavier
- IS-MCT-STA-L2.logUploaded byImroze
- English for Economic_chap2Uploaded byTu Anh Phan
- F.C.F.-Attract-High-End-Client-Now-Ebook-Lead-Magnet-1 (1).pdfUploaded byCasseySeow
- Business\Uploaded byaqsa_munir
- gate 2018 question paperUploaded byJaswant Singh
- Quiz 8Uploaded byLITTLE HEARTS JOHN
- MOJO ExtremesUploaded byValuEngine.com
- VEDP_FY08Uploaded byIntelligenx
- Natural Gas for SpreadexUploaded bymsturdy
- Assignment 1Uploaded bySwati Verma
- Market as a Social InstitutionUploaded byMikio Norberte
- what is business slidesUploaded byheonhocao

- Training ROI StetarUploaded bySiddharth Jain
- The Malone Complex Presentation - 2014.11.19 VPublicUploaded byValueWalk
- customerneeds-11934704-q2Uploaded byAmit Gupta
- Corporate Disclosure and Investor ProtectionUploaded byMatharu Knowlittle
- CH07 Solutions.docxUploaded byasflkhaf2
- AS-10-Revised-Notes.pdfUploaded byvignesh_viki
- 2012 AICPA Auditing QuestionsUploaded byblackseth
- Introduction to Mutual Fund and Its Various AspectsUploaded byNaazlah Sadaf
- FRM1Uploaded bysriharshini
- FinTree- FRA Sixty Minute GuideUploaded byUtkarsh Jain
- Ip Eco515 Managerial EconomicsUploaded bySiddharth Singh
- The Research on the Effects of Capital Structure on Firm PerformanceUploaded byIsabel Ho
- Estimated WACC of Commodity trading CompaniesUploaded bydxkarthik
- Have IFRS Affected Earnings Management in the European Union?Uploaded byGhazi Kallel
- Credit Markets Weekly - MalaysiaUploaded byJackson Hole
- strategic managementUploaded bychitu1992
- 125038523-Business-Plan-UniKL-Template-Jan2013.docUploaded byMuhammad Basiir Harun
- Bryan Hawker & BKH Holdings Group, Inc. Board of Directors Has Unanimously Approved the Decision to Engage in Further Discussions to Purchase National Auto DealershipsUploaded byPR.com
- 2Uploaded byNoreen
- 4 Ps- Rural MarketingUploaded byRahul Vijaykumar
- Glanbia AR2013 WebUploaded byFaidhi Fahmi
- 1-s2.0-S0969698916300042-mainUploaded byMuhammad Bilal
- ch13ans4eUploaded bycoffeedance
- Final Management Project_SubmittedUploaded byKhom Rab Bae
- Bergerac SystemsUploaded bygogana93
- Differences Between US GAAP, Indian GAAP and International Accounting StandardsUploaded byAmitesh Pandey
- Economic IaUploaded bySheka Talya Henry
- 19Uploaded bySofi Jailani
- Hom WworkUploaded byAshish Bhalla
- Audit PlanningUploaded byastriasiregar