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Implied volatility basically means that if you have a call option with X

strike price, Y current market price of underlying and Z contract


premium, whatever Z is, will determine what the implied volatility of
the option is which is what the market thinks the volatility is. All of
these factors go into the black schole model.
Options are quoted in terms of implied volatility. The price of an option
depends most directly on the price of its underlying asset. So if the
implied volatility is high, the option price will increase leading implied
volatility to lower.
Early exercise models (binomial) for American options, Black Scholes
for European (Black Scholes doesnt handle early exercise very well).
Summary of other central banks interest rates
central bank interest rate

region

FED interest rate

United States

RBA interest rate


BACEN interest rate

percentage

date

0.250 %

12-16-2008

Australia

2.500 %

08-06-2013

Brazil

11.000 %

04-02-2014

BoE interest rate

Great Britain

0.500 %

03-05-2009

BOC interest rate

Canada

1.000 %

09-08-2010

PBC interest rate

China

6.000 %

07-06-2012

ECB interest rate

Europe

0.150 %

06-05-2014

BoJ interest rate

Japan

0.100 %

10-05-2010

CBR interest rate

Russia

8.000 %

07-25-2014

SARB interest rate

South Africa

5.750 %

07-17-2014

Risk free rate the higher the rate, the more that country is trying to
control inflation (due to too much growth).
For European options, the higher the interest rate, the higher the call
price (and the lower the put price), and the higher the dividend rate,
the higher the put price (and the lower the call price).
With 0 interest rate and 0 dividend, both call and put are the same for
in-the-money option.
The longer the time period, the higher the option value given high
volatility.
Tbills 1 year or less maturity 0 coupon
Treasury notes 2 to 10 years maturity 10 yr note most important
Currenty 10-yr rate is 2.49%. Back in 1996, the 10-yr was at 6.65%
and the 3 month was at 5.25%. Now 3-month tbill is at .03%.
In 2008 the 1-month Tbill went from 3.09 to .11 within 1 year.
Treasury bond 20-30 years. 30yr bond most common

TIPS: Treasury inflation protected securities inflation indexed bonds


adjusted to CPI (consumer price index). If CPI goes up, principal is
adjusted upwards. Coupon is constant but generates different amount
of interest depending on the inflation adjusted principal. Offered on 5yr, 10 yr and 30 yr mat.
You can buy treasuries online at treasurydirect. Incredible.
Recovery swap: looks like CDS but is called RDS (recovery default
swap). So usually two parties are betting on the recovery rate for
distressed debt of a company that is no longer liquid. The reference
price is set to fixed recovery rate rather than 100. If the reference
entity does not default, RDS is worth 0 and expires at 0. The main
market in RDS involves bonds high risk of default. You can either be
paying or receiving fixed recovery.
AIG selling massive amts of CDS during 2008 so exposed them to
potential losses.
Difference between CDS and insurance is insurance people actually
lose in event whereas cds can be used to speculate.
The premium that the buyer of protection pays to the seller is called
the spread. Premium is quoted in basis points per year of the
contracts notional amount. The payment is made quarterly.
If spread is 976 basis points for 1,000,000, then protection costs
97,600 per year or 24,400 per quarter. (Spread is usually 100 or 500
which translates into 1% or 5%). CDS spreads do not predict risk but
do show you perceived risk.
Credit Spread 01 (CS01) change in MV of CDS in response to 1bp
change in the spread.
Credit curve 6month to 10Y. If near term spread is smaller than long
term spread, it means probability of default is less near term than long
term.
On Bloomberg, you can figure out implied default probability if spread
is 550 at 1-year, then the implied default probability is near 10% of
default.
Duration increases a lot depending on number of years to maturity a
CDS has. So if you have 5 years to maturity, divide 100/5 and you get
how many basis points of spread represents 1 point of price
movement. (20 bps).

Delta hedging options usually necessary if you are selling a call


option, then you buy the underlier in the quantity where you are
hedging out the negative delta from selling the call option.
Binomial options pricing used to value American and Bermudan
options. Bermudan options are those with multiple dates where you
can exercise. Binomial tree = binomial lattice.
Current price * Up factor or Down factor, these are calculated as a
function of underlying volatility and time duration. Down factor = 1/Up
factor.
The higher the coupon rate, the lower the convexity or market risk of a
bond because if the coupon rate is high, market rates would have to
increase greatly to surpass coupon on the bond.
The larger the convexity, the larger the price change due to a given
change in yield. Zero coupon bonds have the highest convexity.
Callable bonds have negative convexity at certain price-yield combos,
because if the yield goes below a certain point, while in normal
circumstances price will go up, for callable bonds there is high chance
issuer will call back the bond, so that means the price will not go up
nearly as much.
MBS are prepayable, so they pay down early when rates fall and later
when rates rise.

A Delta of 0.40 also means that given a $1 move in the underlying stock, the option will likely gain
or lose about the same amount of money as 40 shares of the stock.

Delta grows the more closer you get to the strike price, at the strike
price is .5 (at the money). Then whether you get out of the money or
in the money, the delta of the option will get smaller and flatten out to
either 0 or 1.
VaR on a 1 day time horizon, VaR will say that 1 day out of 20 (at
95% confidence level), you will lose whatever the VAR is due to market
movement.
Identify the risk factors that affect securitys value. 10 year treasury
bond, the risk factors would be points on the discount curve (or yield
curve). The link between risk factors and securities allow us to
compute the value of a security in any scenario.

Equity option risk factors: underlying equity price, discount curve, and
implied volatility.
Tails are usually fatter than a standard normal distribution (based off
the log function).
For VaR calculation, if volatility is an explicit input, then decay factor
will change resulting value for historical var.
Parametric VaR: This model estimates VaR directly from the standard
deviation of portfolio returns.
Lognormally distributions on any random variable only have positive
values.
Parametric calculations are faster than simulation and historical,
because they only need the correlation and volatility matrices. Not
good for long horizons, portfolios with many options, or for assets with
skewed distributions.
Parametric VaR = market price * volatility. For any given confidence
level, that multiple (z-score) will be used to multiply to standard
deviation. So .95 confidence level means 1.65* standard deviation.
(The higher the confidence level, the higher the Z-score, which means
the higher the VaR). .99 confidence level volatility would be 2.33*
standard deviation.
If calculating parametric var for 2 securities, you add the squares of
both of their vars, then add 2*correlation*var1*var2 and you squareroot all of that. (Kind of like the probabilities of portfolio building). So
if correlation is .55, then you use that.
Remember that covariance = correlation * var1*var2. Which = beta.
For monte carlo pricing, every position is repriced, so this is best for
portfolios with derivatives that have embedded options. For equities,
the risk factor is the time series of closing prices transformed into daily
returns.
If you use a weekly frequency, return horizon is 5 business days
monthly frequency, return horizon is 22 days?
Each return is simulated by 100 random numbers based off of the past
100 time series dates. So each days return is randomly paired with a
random number, and that gets you 1 iteration. Then you add up all
100 iterations to get 1 return.

With historical var, instead of generating a new returns distribution, we


use the historical distribution directly. Sometimes historical vars have
higher chance of capturing fat tails.
Higher than normal implied volatility is good for option sellers because
it means the premiums are worth more, and volatility eventually goes
back to mean. Compare historical volatility to implied volatility.
Over a 3 month period, decay happens faster than 6 months.
MBS are a function of two interest rate factors the level and slope of
the term structure. Then comes into play moneyness of the
prepayment option, expected level of prepayments, and average life of
MBS cash flows. Term structure slope controls for the average rate.
Freddie Mac and Fannie Mae both sell MBS people buy these, and then
in term these two corporations can buy mortgage loans from the
secondary market (from primary lenders). When the government buys
MBS again, brings down interest rates.
Ginnie Mae (FHA) FHA = federal housing administration. They do
bonds that have the backing of the federal government. Ginnie Mae
insures a bond that is backed by the mortgages (mbs?) and if the
borrower defaults, bank can collect from Federal housing
administration. Accounts for 10% of the MBS market.
If interest rates fall, many homeowners will refinance their homes,
investors will get back their principal sooner than expected. So
basically, MBS investors are implicitly selling a call option on a fixed
rate bond homeowners who choose to exercise this call option (when
the interest rate goes down), will end up prepaying and causing
investors to get their money back sooner than later. Then when
investor gets their money back, the immediate investment alternative
is now at a lower coupon rate. Hence there is negative convexity
between price of MBS and price of default-free bonds. (concavity).
To hedge out interest rate risk, buy a 3 month and 10 yr interest rate
future.
For a 10% ginnie mae mbs, if the 10-yr rate is at 5.5%, then price of
GNMA mbs is at 110, but if 10-yr tnote rate is at 9.5%, then mbs price
is at 98$. If the tnote rate is 9.5% above an 8% GNMA mbs, then the
price will be 85 (because of the high chance of prepayment).
Interest rate caps basically series of call options on interest rates,
pays difference between reference rate and cap rate (once reference

rate goes above cap rate, you profit from interest rate cap). Interest
rate floor is opposite once reference rate goes below floor rate, then
you profit, receiving floor rate reference rate profit.
Caplet = single payment on a cap.
Interest rate collar = long position in a cap plus a short position in the
floor so this puts upper and lower bounds on floating interest rate
payments.
Swaptions are basically options on bonds you have a claim to swap at
whatever rate. You only need to value the fixed rate side because
floating side trades at par.
Swaption pricing model using black scholes, were using the forward
starting swap rate, the strike rate, the number of payments per year,
the time between payments, the maturity of swaption in periods, the
maturity of swaption in years, annualized volatility, and a normal
distribution function.
Swap curve interest rates paid on interest rate swaps. Spreads
between swap rates and Treasury bonds. Swaps = replacement for
treasury bonds as a financial benchmark. The notional for IRS never
gets exchange, only net interest payments between the two swap
counterparties.
Underlying instrument in Eurodollar futures is the Eurodollar time
deposit principal value of 1m with 3 month maturity. Futures prices
are expressed as 100 minus the 3-month LIBOR. So if the price is 95,
this means LIBOR is 5%. 1bp change equals 25$ per contract gain. So
if you need to hedge against increase in interest rates, you can short
sell a Eurodollar future contract, because when the value of the
Eurodollar future goes down, you gain. Of course, interest rate will go
up which means you will be paying more LIBOR, but at least you gain
from short selling Eurodollar future. LIBOR is a Eurodollar rate.
Arbitrage between short term US CD rates and 3-month LIBOR means
they stay almost the same. Overnight libor = overnight federal funds
interest rates.
Swaps are basically derivatives on the LIBOR rate. LIBOR is actually
calculated for a bunch of securities, but usually refers to the US Dollar
rate. LIBOR maturities are 1 week, 1, 2, 3, 6, 9, and 12 months. More
swaps are done on LIBOR than on US treasury rate, perhaps why this is
now a benchmark.

Quanto swaps are where you pay the fixed rate in dollars but get the
floating rate in another currency like JPY or EUR.
The swap rate is the fixed rate that receiver demands in exchange for
the uncertainty for having to pay the LIBOR rate over time. Swaps are
either quoted at this fixed rate, or the swap spread which is the
difference between the swap rate (the fixed rate) and the US Treasury
bond yield.
Pricing fx option: spot price, volatility, strike, and time to expiry. Strike
and its proximity to spot is one of the major influences of option
premium price. At the money forward or at the money spot have
different strike prices.
Volatility surface drawn from large # of contributor banks.
(Bloomberg)
Implied volatility surface plotted with implied volatility points for a
given delta and days to maturity set. Apparently implied volatility is
highest for options with high delta and few days to maturity.
Shortcoming of black scholes assumes that underlying volatility is
constant over life ot eh derivative and unaffected by changes in the
price level of undl security. So volatility surface shows us how price is
affected by changes in delta and time to maturity.
SABR volatility model stochastic volatility model, captures the
volatility smile in derivatives markets. Stands for Stochastic alpha,
beta, rho. Used in interest rate derivatives markets.
Risk-neutral measure: implies that in a complete market a derivatives
price is the discounted value of future payoffs.
Covariance is basically just the return of the asset minus the average
return of asset multiplied by the same difference in asset 2. So (xavgx)*(y-avgy)
Correlation is equal to covariance /stdA*stdB so covariance =
correlation * stdA*stdB
CML equation = expected return of complete portfolio = risk free rate
+ std complete * (expected return of portfolio) risk free divided by
std portfolio
The steeper the CML, the more utility (the higher the sharpe ratio).

Use commodity basis swaps to hedge against illiquid trading


commodity options such as Gulf Coast jet fuel prices. If you are trying
to hedge against gulf coast jet fuel prices going up, and you buy a
commodity future option call on NYMEX heating oil future, you need a
commodity basis swap between gulf coast jet fuel and NYMEX heating
oil to hedge out the basis risk.
Basis risk is basically the difference in price difference between a
futures market and a cash spot market.
So if we are locking in a basis of a swap, something like .05 per gallon,
means you are locking in the difference between the jet fuel and the
heating oil futures. No matter what happens to the basis (i.e. the basis
goes to .1, you will receive a return of .05 because you locked in the
swap).
For using commodity futures to hedge, sellers of energy will sell the
gas future so that in case the price of commodity goes down, they will
make less money selling the energy but at least they will gain money
on the difference between the current price and future price.
Meanwhile, buyers of energy will buy futures and so if the price goes
up, they will pay more but they will alsy make money from the price
differential between the futures price and the current price.
Energy consumers use swaps to lock in energy costs while producers
use swaps to lock in revenues/cash flows.
Buy purchasing call options, an energy consumer can hedge against
rising costs while suffering little downside cost (the premium of the
option).