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Thomas S. Coleman
September 1997
Overall Themes
Discounting Expected Cash Flows Use Simplest Model Which Solves Problem Focus on Hedging and Managing Risks
September 1997
Focus on specific example - call on 2 vs. 10 year swap yields Two contrasting views Two underliers: Y10 - Y2
Correlation matters
Discount ECF using risk-neutral measure Take expectation of payout: E[(Y10 - Y2) - K | (Y10 - Y2) > K ]
or
E[S - K | S > K ]
September 1997
Principle of using simplest model which fits Here we can use simple model
Option is European Depends on two variables - Y10 & Y2
September 1997
Now must make some decisions What are some reasonable assumptions about Y10, Y2, and S?
ln(Y10) & ln(Y2) jointly normal with correlation S normally distributed with standard deviation s
g(S) =
(S - F) 2 exp 2 2 2s t 2 s t 1
For US
3 mth fwd 2 year rate 3 mth fwd 10 year rate Forward spread LN volatility of 2 year LN volatility of 10 year Historical correlation Spread standard deviation
Risk Swap Course
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Spread Option - Hedging Difficult to hedge Flip side of difficulty in choosing level of s or Usually must live with the correlation / spread standard deviation risk To hedge trade the spread - delta hedge
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Two ways of measuring risk for ATM Risks to spread and spread std. dev.
1bp in spread 0.5bp 1bp in std. dev. 0.2bp
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PV(Y)g(Y; Y
0
, ) dY = PV(Y )
f
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PV of call is
NPV = DF(3mth)st.5[(d) + d(d)] d = (F-K)/ st.5
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Find mean of distribution for which PV(Y ) g(Y; Y m , ) dY = PV(Y f ) 0 Various methods
Brute force numerical integration Approximate integrand by piece-wise quadratic More sophisticated approximations
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Convexity - Hedging
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Convexity - Libor-in-Arrears
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Convexity - Libor-in-Arrears
Example
Quarterly libor, adjustment 0.5bp at 1yr, 2.4bp at 5yr Annual libor, adjustment 1.8bp at 1yr, 9.2bp at 5yr
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Conclusion
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d<0
d>0
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Problem 3 - Answers
Yr of pmt 1 2 3 4 5
NPV (sprd) 1.59 2.98 4.93 6.67 7.91 24.09 5.82 5.70
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