Professional Documents
Culture Documents
Management Conclusions
This research is supported by CARF (Center for Advanced Research in Finance) and the global COE program The research and
training center for new development in mathematics. All the contents expressed in this research are solely those of the authors and do
not represent the views of any institutions. The authors are not responsible or liable in any manner for any losses and/or damages caused
by the use of any contents in this research. M.Fujii is grateful for friends and former colleagues of Morgan Stanley, especially in IDEAS, IR
option, and FX Hybrid desks in Tokyo for fruitful and stimulating discussions. The contents of the research do not represent any views or
opinions of Morgan Stanley.
1 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Outlines
1
Introduction
General Needs
Problems in Textbook-style Implementation
Implications for Financial Firms
Review of Recent Works and Un-addressed Issues
Risk Management
Conclusions
Electronic copy available at: http://ssrn.com/abstract=1556487
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Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
3 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
General Needs
General Needs
Single Currency products
Swap
Swaption, Cancellable Swap, Cap/Floor.
TARN/Callable/Range Accrual of CMS, CMS-spread,
Inverse Floater, etc.
Multi-Currency products
Short term Vanilla FX products
Cross Currency Swap
TARN/Callable/Knockout of PRDC, PRDC with chooser option
Quantoed CMS, CMS-spread, etc.
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Problems in Textbook-style Implementation
Textbook-style Implementation
Q
Q
(Et [] E Q [|Ft ])
Pt,T = Et exp tT r(s)ds
Q: The Equivalent Martingale Measure(EMM) or the risk-neutral
measure, where the numeraire is the money market account.
Asset prices as well as all the factors and indexes aecting the asset
prices are assumed to follow It
o processes.
5 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Problems in Textbook-style Implementation
Textbook-style Implementation
Curve Construction
Most Standard IRS : Fixed-vs-Libor
xed
libor
Exchange Fixed Rate (Swap Rate) with Libor
Market Quotes are the Swap Rates for various terms
IRSM (t)
m=1
m Pt,Tm =
m=1
6 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Problems in Textbook-style Implementation
Textbook-style Implementation
1
m
Pt,Tm1
Pt,Tm
)
1
M 1
m=1
m Pt,Tm
1 + IRSM (t)M
7 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Problems in Textbook-style Implementation
Textbook-style Implementation
Simulation based on
Arbitrage-free dynamics of risk-free rate
Arbitrage-free dynamics of spot FX
8 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Problems in Textbook-style Implementation
9 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Problems in Textbook-style Implementation
We will see...
List of problems:
wrong discounting for secured (collateralized) trades
mispricing of various important swaps
Tenor Swap (TS)
Cross Currency Swap (CCS)
FX Forward
Overnight Index Swap (OIS)
.
10 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Problems in Textbook-style Implementation
1 It
is also common that payment of short-tenor Leg is compounded and paid at the
same time with the other Leg.
11 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Problems in Textbook-style Implementation
Figure: Source:Bloomberg
.
12 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Problems in Textbook-style Implementation
Figure: Source:Bloomberg
.
13 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Problems in Textbook-style Implementation
USD Libor(3m)
14 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Problems in Textbook-style Implementation
Figure: Source:Bloomberg
.
15 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Problems in Textbook-style Implementation
Cash=PV
Cash
Loan
Libor
B
option payment
16 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Problems in Textbook-style Implementation
cash=pv
collateral
col. rate
loan
17 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Problems in Textbook-style Implementation
18 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Problems in Textbook-style Implementation
Compounded ON
19 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Problems in Textbook-style Implementation
Figure: Source:Bloomberg
.
20 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Implications for Financial Firms
21 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Implications for Financial Firms
Firm
Client
Libor+fee
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Review of Recent Works and Un-addressed Issues
V.Piterbarg (2010)
Pricing formula for the collateralized stock options similar to the one
given in M.Johannes et.al. (2007).
Treating partially collateralized case, but the counter-party default risk is
neglected.
23 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Review of Recent Works and Un-addressed Issues
IRSN
n=1
{
NJP Y
n Pt,Tn =
Pt,T0 +
{
= fx (t)
n=1
N
(
)
n EtTn [L(Tn1 , Tn ; )] + bN Pt,Tn + Pt,TN
n=1
$
Pt,T
0
$ Tn,$
$
n
Et
[L$ (Tn1 , Tn ; )]Pt,T
n
}
+
$
Pt,T
N
(
)
=0
n=1
n=1
24 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Review of Recent Works and Un-addressed Issues
Bianchetti (2008)
Using FX analogy to remove arbitrage possibility in multi-curve setup.
Calibration of basis spreads needs to be done by quanto correction.
Curve construction cannot be separated from option calibration.
No guarantee that one can recover the observed basis spreads with
reasonable size of volatility and correlation.
25 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Review of Recent Works and Un-addressed Issues
F.Mercurio (2008)
Introducing an ecient simulation scheme with multiple curves in Libor
Market Model in single currency environment.
Referring to the work of Ametrano et.al. (2009) for details of curve
construction and assuming the existence of constructed yield curves.
26 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Review of Recent Works and Un-addressed Issues
27 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Criteria for the New Model
Criteria
Consistent discounting/forward curve construction
Price all types of IR swaps correctly:
(OIS, IRS, TS)
Take collateralization into account.
Maintain consistency in multi-currency environment
(FX forward, CCS, MtMCCS)
.
28 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Criteria for the New Model
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Pricing under the Collateralization
Assumption
Continuous adjustment of collateral amount
Perfect collateralization by Cash
No threshold
Comments
30 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Pricing under the Collateralization
.
31 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Pricing under the Collateralization
h(i) (s)
,
(i,j)
fx
(s)
h(i) (t) = Et
(i,j)
+fx
Qi
= Et
[
T
e t
[
T
e t
Qj
r (i) (s)ds
(t)Et
r
(i)
(s)ds
]
h(i) (T )
s
t
(
r (j) (u)du (j)
(s)
h(i) (s)
(i,j)
fx
h(i) (T ) +
s
t
(i)
(u)du (j)
]
ds
(s)
]
(s)h(i) (s)ds .
(i,j)
t
0
r (i) (s)ds
h(i) (t)+
s
0
(s)h(i) (s)ds
32 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Pricing under the Collateralization
y (j) (s)ds
(
s
t
)
y (j) (u)du ,
(
)
(i,j)
h(i) (T )/fx
(T ) .
Hence, we obtain
h(i) (t)
=
=
[
]
T (i)
(i,j)
(i,j)
Q
V (j) (t)fx
(t) = Et i e t r (s)ds V (j) (T )fx
(T )
[
( T (j)
)
]
T (i)
Q
Et i e t r (s)ds e t y (s)ds h(i) (T ) .
33 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Pricing under the Collateralization
.
34 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Curve Construction
n Et
[
Tn
e t
n=1
c(s)ds
[
Q
Et
Tn
t
(
c(s)ds
Tn
Tn1
)]
c(s)ds
n=1
or, equivalently,
OISN (t)
n=1
35 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Curve Construction
IRSM (t)
m=1
Collateralized TS
N
m D(t, Tm ) =
Tc
m=1
(
)
]
Tc [
n D(t, Tn ) Et n L(Tn1 , Tn ; S ) + T SN (t)
n=1
]
Tc [
m D(t, Tm )Et m L(Tm1 , Tm ; L )
m=1
36 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Curve Construction
OIS, IRS, TS
Repeat the same procedures in the previous section.
Obtain {D (i) (t, T )},
currency i
Tc
37 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Curve Construction
(i,j)
fx
(i,j)
fx
[
]
T (i)
T (k)
e t r (s)ds e t y (s)ds
[
]
T (j)
T (k)
e t r (s)ds e t y (s)ds
Qi
(t, T )Et
Qj
(t)Et
and then,
T(j)
E
(j) (t, T )
P
t
(i,j)
(i,j)
fx
(t, T ) = fx
(t) (i)
P (t, T ) E T(i)
t
[ T
e t
[ T
e t
y (k) (s)ds
y (k) (s)ds
] .
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Curve Construction
Assumption
Spread between the risk-free and collateral rate of each currency
y (i) (t) = r (i) (t) c(i) (t)
is a deterministic function of time.
We will achieve:
.
39 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Curve Construction
=
=
=
Qi
[
T
e t
r (i) (s)ds
( T
e t
y (j) (s)ds
h(i) (T )
[
]
T (j)
T(i)
P (i) (t, T )e t y (s)ds Et
h(i) (T )
[
]
T (j,i)
(s)ds T(i)
D (i) (t, T )e t y
Et
h(i) (T ) ,
Et
where y (j,i) (s) = y (j) (s) y (i) (s) . On the other hand,
[
]
T (i)
T (j,i)
Q
(s)ds (i)
h(i) (t) = Et i e t c (s)ds e t y
h (T )
c [
]
T (j,i)
T(i)
(s)ds
= D (i) (t, T )e t y
Et
h(i) (T ) ,
and thus,
c
T(i)
Et
[
]
[
]
T(i)
h(i) (T ) = Et
h(i) (T ) .
40 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Curve Construction
fx
(t, T )
(i,j)
fx
(t)
D (j) (t, T ) T
P (j) (t, T )
(i,j)
= fx
(t) (i)
e t
(i)
P (t, T )
D (t, T )
y (i,j) (s)ds
D (j) (t, T ) tT
e
D (i) (t, T )
y (i,j) (s)ds
Except the y (i,j) , all the variables are already xed or observable
in the market.
It can be used only for relatively short maturities due to liquidity
reason.
41 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Curve Construction
P Vi (t) = Et
+
(i)
Qj
P Vj (t) = Et
N
Qi
n Et
n=1
[
T0
e t
(j)
c(i) (s)ds
[
Tn
e t
]
Qi
+ Et
c(i) (s)ds
[
TN
e t
c(i) (s)ds
L(i) (Tn1 , Tn ; )
) ]
) ]
[
[
T0 ( (j)
TN ( (j)
Q
r
(s)y (i) (s) ds
r
(s)y (i) (s) ds
e t
+ Et j e t
Qj
n Et
)
[
Tn ( (j)
(
)]
r
(s)y (i) (s) ds
CCS
e t
L(j) (Tn1 , Tn ; ) + BN
(t)
n=1
42 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Curve Construction
After simplication,
P Vi (t) = D (i) (t, T0 ) + D (i) (t, TN )
+
c
Tn,(i)
(i)
[
]
L(i) (Tn1 , Tn ; )
n=1
T0
(j)
Tn
n D (j) (t, Tn )e
y (i,j) (s)ds
TN
(i,j)
(s)ds
+ D (j) (t, TN )e t y
(
)
c
[
]
Tn,(j)
y (i,j) (s)ds
CCS
Et
L(j) (Tn1 , Tn ; ) + BN
(t) ,
n=1
43 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Curve Construction
44 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Two dierent types of Cross Currency Swap
45 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Two dierent types of Cross Currency Swap
(i,j)
fx
Nj 1
Ni Li
(i,j)
(Ni = Ni + fx
)
Ni Li
46 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Two dierent types of Cross Currency Swap
=
=
Tc
Et k [L(Tk1 , Tk ; )]
[
(
)]
1
1
Tc
Et k
1
k D(Tk1 , Tk )
(
)
D(t, Tk1 )
1
1
k
D(t, Tk )
47 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Two dierent types of Cross Currency Swap
) ]
) ]
[
[
TN ( (j)
T0 ( (j)
Q
(s)y (i) (s) ds
r
(s)y (i) (s) ds
r
+ Et j e t
e t
Qj
)
[
Tn ( (j)
(
)]
r
(s)y (i) (s) ds
MtM
e t
L(j) (Tn1 , Tn ; ) + BN
(t)
P Vj (t) = Et
N
(j)
n Et
n=1
Tn
(j)
n D (j) (t, Tn )e
y (i,j) (s)ds
n=1
Tn1
(
)
MtM
B (j) (t, Tn ; ) + BN
(t)
(
y (i,j) (s)ds
Tn
Tn1
y (i,j) (s)ds
)
1
n=1
48 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Two dierent types of Cross Currency Swap
(i,j)
Ni = fx
(t)
(i,j)
fx
Nj = 1
P Vi (t) =
Qi
Et
Nj = 1
[
Tn1
e t
c(i) (s)ds
(i,j)
fx
]
(Tn1 )
n=1
Qi
Et
[
Tn
e t
c(i) (s)ds
(i,j)
fx
(
)]
(i)
(Tn1 ) 1 + n L(i) (Tn1 , Tn ; )
n=1
n=1
(i)
c
Tn,(i)
[
]
(i,j)
fx
(Tn1 )B (i) (Tn1 , Tn ; )
49 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Two dierent types of Cross Currency Swap
[
{
T0
Q
Ni Et i e t
N
(i)
Qi
n Et
c(i) (s)ds
[
Tn
e t
]
Qi
+ Et
c(i) (s)ds
[
TN
e t
c(i) (s)ds
}
]
L(i) (Tn1 , Tn ; )
n=1
Ni
(i)
n=1
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Two dierent types of Cross Currency Swap
(i)
c
Tn,(i)
E
t
(j)
n
(i,j)
fx
(Tn1 )
(i,j)
fx
y (i,j) (s)ds
(t, Tn )
Tn1
(i)
(Tn1 , Tn ; ) B
(
y (i,j) (s)ds
Tn
Tn1
}
(j)
(t, Tn ; )
y (i,j) (s)ds
)]
1
n=1
n=1
(j)
Tn
n D (j) (t, Tn )e
y (i,j) (s)ds
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Two dierent types of Cross Currency Swap
y (i,j) (s)ds
n=1
(i)
N (i)
(j)
(i,j)
fx
(j)
}
B
(i)
(t, Tn )
(t, Tn ; ) B
Tn1
(t, Tn1 )e
(j)
(t, Tn ; )
(
y (i,j) (s)ds
Tn
Tn1
y (i,j) (s)ds
)]
1
n=1
n=1
(j)
Tn
n D (j) (t, Tn )e
y (i,j) (s)ds
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Two dierent types of Cross Currency Swap
{
}
(i)
(i)
(i)
P Vi (T ) = Ni DT ,T S L(TS1 , TS ; ) + DT ,T
S
+ Ni
(i)
n ET i
[
Tn
e T
(i)
(s)ds
]
L(i) (Tn1 , Tn ; )
n=S+1
(i)
Ni DT ,T
S
(
)
(i)
1 + S L(i) (TS1 , TS ; ) +
n=S+1
(i)
(i)
DT ,Tn n B (i) (T , Tn ; )
53 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Two dierent types of Cross Currency Swap
P Vi (T ) = fx
N
ET i
(i)
(TS1 )DT ,T
[
Tn1
e T
(i)
(
)
(i)
1 + S L(i) (TS1 , TS ; )
(s)ds
(i,j)
fx
]
(Tn1 )
n=S+1
[
Tn
Q
ET i e T
n=S+1
(i,j)
= fx
+
(i)
(TS1 )DT ,T
(i)
(i)
c(i) (s)ds
(i,j)
fx
(
)]
(i)
(Tn1 ) 1 + n L(i) (Tn1 , Tn ; )
(
)
(i)
1 + S L(i) (TS1 , TS ; )
c
Tn,(i)
DT ,Tn n ET
[
]
(i,j)
fx
(Tn1 )B (i) (Tn1 , Tn ; )
n=S+1
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Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Two dierent types of Cross Currency Swap
Ni
(i,j)
fx
(T )
(i,j)
fx
(T )
{
(
)
(i)
(i)
DT ,T
1 + S L(i) (TS1 , TS ; )
S
(i)
(i)
DT ,Tn n B (i) (T , Tn ; )
n=S+1
MtMCCS
(i,j)
P Vi (T )
(i,j)
fx
fx
(T )
(TS1 )
(i,j)
fx
+
n=S+1
(i)
(T )
(i)
(i)
DT ,T
c
Tn,(i)
DT ,Tn n ET
(
)
(i)
1 + S L(i) (TS1 , TS ; )
[
(i,j)
fx
(Tn1 )
(i,j)
fx
]
B (i) (Tn1 , Tn ; )
(T )
55 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Two dierent types of Cross Currency Swap
56 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Term Structure Model with Basis spreads and Collateral
or
ln D(t, T )
T
(
D(t, T ) = exp
)
c(t, s)ds
Proposition
The SDE of the forward collateral rate under the Money-Market measure Q is
given by
( s
)
dc(t, s) = c (t, s)
c (t, u)du dt + c (t, s) dW Q (t) ,
t
57 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Term Structure Model with Basis spreads and Collateral
c(t)
(
(t, s)ds +
t
2 }
1 T
(t,
s)ds
dt
c
2 t
)
Q
c (t, s)ds dWt .
(
[c (t, s)]j
j=1
s
t
c (t, s)
)
c (t, u)du
)
c (t, u)du .
58 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Term Structure Model with Basis spreads and Collateral
Proposition
The SDE of Libor-OIS spread in Money-Market measure is given by
dB(t, T ; )/B(t, T ; )
(
)
T
= B (t, T ; )
c (t, s)ds dt + B (t, T ; ) dW Q (t) .
t
59 / 75
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Term Structure Model with Basis spreads and Collateral
Bootstrap {D(t, T )} and {Et m [L(Tm1 , Tm ; )]} from OIS, IRS and TS.
Construct continuous curves for the forward collateral rate and Libor-OIS
spread of each tenor.
Initial conditions: {c(t, s)}, {B(t, T ; )}.
Simulation based on SDEs:
)
( s
dc(t, s) = c (t, s)
c (t, u)du dt + c (t, s) dW Q (t)
t
dB(t, T ; )/B(t, T ; )
= B (t, T ; )
)
c (t, s)ds dt + B (t, T ; ) dW Q (t)
.
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Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Term Structure Model with Basis spreads and Collateral
dW Qi (t) = X
(t)dt + dW Qj (t) ,
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Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Term Structure Model with Basis spreads and Collateral
dfx
(t)
(i,j)
fx
(t)
(
)
(i,j)
= c(i) (t) c(j) (t) + y (i,j) (s) dt + X (t) dW Qi (t)
(
(i)
)
(i)
(i)
c (t, u)du dt + c (t, s) dW Qi (t)
dB (i) (t, T ; )
(i)
= B (t, T ; )
B (i) (t, T ; )
)
(i)
c (t, s)ds dt
(i)
+B (t, T ; ) dW Qi (t)
[( s
)
]
(j)
(j)
(i,j)
c (t, u)du X (t) dt
dc(j) (t, s) = c (t, s)
t
(j)
+c (t, s) dW Qi (t)
[( T
)
]
dB (j) (t, T ; )
(j)
(j)
(i,j)
=
(t,
T
;
(t,
s)ds
(t)
dt
c
B
X
B (j) (t, T ; )
t
(j)
+B (t, T ; ) dW Qi (t)
.
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Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Term Structure Model with Basis spreads and Collateral
Tc
Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
A(t, T0 , TN )
D(t, T0 ) D(t, TN )
A(t, T0 , TN )
N
n D(t, Tn )
n=1
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Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
( Tn
)
N
1
n D(t, Tn )
c (t, s)ds dt
A(t, T0 , TN ) n=1
t
dOIS(t, T0 , TN )
+
( T
)
N
D(t, TN )
c (t, s)ds
D(t, T0 ) D(t, TN )
T0
( Tn
)}
N
c (t, s)ds
dW A (t)
n D(t, Tn )
OIS(t, T0 , TN )
1
A(t, T0 , TN )
n=1
T0
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Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
[(
)+ ]
OIS(T0 , T0 , TN ) + SpOIS (T0 , T0 , TN ; ) K
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Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
N
SpOIS (t, T0 , TN ; ) =
n D(t, Tn )B(t, Tn ; )
N
n=1 n D(t, Tn )
n=1
( T
)
N
1
j
OIS
OIS
j D(t, Tj )
c (t, s)ds
dSp
(t, T0 , TN ; ) = Sp
(t)
A(t)
T0
j=1
(
)}
N
Tn
1
+
n D(t, Tn )B(t, Tn ; ) B (t, Tn ; )
c (t, s)ds
dW A (t)
Asp (t) n=1
T0
where
Asp (t) =
n D(t, Tn )B(t, Tn ; )
n=1
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Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Qi
[
T
e t
r (i) (s)ds
Et
D (i) (t, T )e
T
t
(
)+ ]
(i,j)
fx
(T ) K
[(
)+ ]
(i,j)
fx
(T , T ) K
y (k) (s)ds
y (k,i) (s)ds
c
T(i)
Et
.
(i,j)
dfx
(t, T )
(i,j)
fx
(t, T )
(i,j)
F X (t, T ) dW
(i,j)
X (t) +
T
t
(i)
c
T(i)
(t)
c (t, s)ds
}
Tc
(j)
c (t, s)ds dW (i) (t)
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Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Risk Management
Risk Management
There are three important points :
Hedges
Monitoring
Risk Reserve
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Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Risk Management
Hedges
Delta Hedge
The most important risk factor for all the books.
Blipping each input of market quotes (1y,2y,...) separately and
perform mark-to-market.
Take the dierence between the original scenario to calculate
the exposure.
Entering the relevant swap to reduce the exposure within a
certain limit.
Accurate modeling of the curve-level dependence on ATMF
volatilities is important for the eciency of the delta hedges.
.
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Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Risk Management
Hedges
Kappa Hedge
A very important risk factor for all the derivative books.
Although the market of basis swaps is liquid enough, derivatives
on spreads and OIS are still quite rare.
IRS and FX kappa hedges would be enough for the daily
operation.
Sensitivities for the change of market implied volatilities rather
than the model parameters are important in practice.
Recalibration for each blipped scenario of implied volatility would
require too much time...
.
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Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Risk Management
A practical method of Kappa Hedge (ATMF)
Choose N hedge instruments with high liquidity.
Label their implied volatilities as {i }N
i=1 .
Use the delta-neutral form of option, such as Straddle.
Partitioning the volatility curves/surfaces into N regions.
Label the partitions as {Vi }N
i=1 . (
)
i
Make sure that N N -matrix,
, is invertible.
Vj
{
}N
P V
j
For each scenario of blipped Vi , calculate
,
.
Vi
Vi j=1
Calculate the exposure to the j-th hedge instrument as
) (
)
N (
Vi
P V
P V
=
j
j
Vi
i=1
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Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Risk Management
Monitoring
Everyday PL decomposition is very important to check the
reliability of hedges and nd a signal of unexpected risk factor, or
bugs of system.
Using the change of market data and the calculated Greeks
such as (Deltas, Gammas, Kappas, Thetas,...) to derive the
expected PLa .
Take the dierence between the actual and the expected PLs,
and check the size and dominant source of residuals.
Understand the cause of residual if it is signicant.
a To
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Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Risk Management
Risk Reserve
There are a lot of risk factors very dicult to hedge in practice. It
requires to hold reasonable amount of risk reserve.
Model limitation.
Illiquidity of basis spread options.
Illiquidity of Far OTM options.
Exposure to correlation change.
Stochastic correlations and their dependence on yield curve
level/slope.
etc...
.
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Introduction Term Structure Model in the Current Market Conditions Pricing of Vanilla Products under the Collateralization Risk Management Conclusions
Conclusions
Conclusions
Textbook-style implementation of IR model is not appropriate
in the current market conditions.
Existence of various basis spreads and their movements
Widespread use of collateral
Signicant implication for prot/loss of nancial rms and their
risk management
.
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