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Financial Primer, second

Financial Primer, second

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You are on page 1of 30

Stochastic Modeling

Symposium

By

Thomas S.Y. Ho PhD

Thomas Ho Company, Ltd

Tom.ho@thomasho.com

April 3, 2006

Purpose

Overview of the basic principles in the

relative valuation models

Overview of the basic terminologies

Equity derivatives

Fixed income securities

Examples of applications

Traditional Valuation

Net present value

Expected cashflows

Cost of capital as opposed to cost of

funding

Capital asset pricing model

Cost of capital of a firm as opposed to cost

of capital of a project (or security)

Relative Valuation

Law of one price: extending to nontradable financial instruments

Applicability to insurance products and

annuities (loans and GICs)

Arbitrage process and relative pricing

Modeling approach: specifying the

assumptions, types of assumptions

Description of an option

Economic assumptions:

Constant volatility

Stock return distribution

Efficient capital markets

Generality of the model in describing the

equity return distribution

Market lattice and risk neutral lattice

Dynamic hedging and valuation

Intuitive explanation of the model results

Comparing the relative valuation approach

and the traditional approach the case of

a long dated equity put option

exist positive state prices such that the price of

any security is the sum across the states of the

world of its payoff multiplied by the state price.

=(Cu Cd)/(Su -Sd )

C = uCu + dCd

S=

1 = uexp(rT)+ dexp(rT)

uSu + dSd

Option Pricing

Stock Price($)

100

100

Stock Volatility

0.2

Risk-free rate

0.05

dividend yields

N/A

dt = T/n

upward movement

1.0851

= exp(dt)

downward movement

0.9216

= 1/u

risk-neutral probability of u

0.5308

= (exp(rdt)-d)/(u-d)

Stock lattice

163.21

4965

stock lattice

time

150.41

8059

138.62

4497

138.62

4497

127.75

5612

117.738

905

127.75

5612

117.738

905

108.50

756

100

117.738

905

108.50

756

100

92.159

4775

84.933

693

108.50

756

100

92.159

4775

84.933

693

78.274

4477

72.137

3221

100

92.159

4775

84.933

693

78.274

4477

72.137

3221

66.481

3791

61.268

8917

63.214965

10.125573

51.247930

38.624497

40.277352

28.585483

17.738905

30.224621

19.391759

9.337430

0.000000

21.723634

12.494533

4.915050

0.000000

0.000000

15.055460

7.780762

2.587191

0.000000

0.000000

0.000000

4.729344

1.361849

0.000000

0.000000

0.000000

0.000000

10

measures

1 = pu + pd

1 = qu + qd

Denominator: numeraire

Martingale: expected value= current value

11

Ito process

(dt)2 =0

(dt)(dB)=0

(dB)2 =dt

Z = g( t, X)

dS/S =dt + dB(t)

S(t) = S(0)exp (t - 2t/2 + B(t))

12

Numeraires and

Probabilities

dV/V = qdt + dS/S dividend re-invested

dY/Y = * dt + *dB*(t) any asset

R(t) = integral of r(s) stochastic rates

Risk neutral measure

Z(t) = V(t)/R(t)

dS/S = (r- q) dt + sdB(t)

V as numeraire

Z(t) = R(t)/V(t)

dS/S = (r q + s2)dt + s dB

13

Y as numeraire

Z(t) = V(t)/Y(t)

dS/S = (r q + s y)dt + s dB

Volatility invariant

14

Martingale process

Examples of measures

Applications in the capital markets

Applications to the insurance products

Life products

Fixed annuities

Variable annuities

15

Sensitivity Measures

Delta , S

Gamma ,

Theta (time decay) t

Vega v measure

Rho , r

Relationships of the sensitivity measures

Intuitive explanation of the greeks

16

100

100

?

Stock volitility ()

0.2

0.04

Dividend yields ()

0

17

Greeks

Call

Put

Price

9.92505

6.00400

(Delta)

0.61791

-0.38209

(Gamma)

0.01907

0.01907

v (Vega)

38.13878

38.13878

(Theta)

-5.88852

-2.04536

(Rho)

51.86609

-44.21286

18

Lattice models

Yield curve estimation

Yield curve movements

Dynamic hedging of bonds

Term structure of volatilities

Sensitivity measures

19

Setting Up

year

0.060

0.060

0.065

0.070

0.075

0.080

1.00000

0

0.94176

5

0.87809

5

0.81058

4

0.74081

8

0.67032

0

0.060

0.060

0.070

0.080

0.090

0.100

0.0775

0.0775

0.0775

0.0775

0.0775

0.0775

0.0775

0.0775

0.0775

0.0775

20

0.86124

1

P (n 1)

i

Pi (1) 2

n

P(n) (1 )

n

0.87964

7

0.87469

5

0.89695

1

0.89200

4

0.88835

8

0.91310

5

0.90814

3

0.90453

4

0.90223

5

0.92805

8

0.92306

6

0.91947

4

0.91724

1

0.91632

8

0.94176

5

0.93672

9

0.93313

6

0.93094

6

0.93012

6

0.93064

2

year

21

0.14938

06

ln Pi n (T )

ri (T )

T

n

0.12823

51

0.13388

06

0.10875

38

0.11428

51

0.11838

06

0.09090

47

0.09635

38

0.10033

51

0.10288

06

0.07466

08

0.08005

47

0.08395

38

0.08638

51

0.08738

06

0.06

0.06536

08

0.06920

47

0.07155

38

0.07243

51

0.07188

06

year

22

P( n 1)

P ( n)

Pi n (1)

1 n1 n2 1 1 n1 2

1 n 1 1 n 2 1 n

ni

0.86673

1

0.926800

0.94176

0.88096

3

0.87807

2

0.89598

0

0.89266

8

0.88956

2

0.9

11

39

5

0.90779

5

0.90453

0

0.90120

1

0.9

23

04

4

0.91976

5

0.91654

9

0.91299

4

0.9

34

23

0.93189

0.92872

0.92494

P ( n 1)

1 n 1 n 2 L 1 L 1 n 1 2

P ( n)

1 n L 1 1 n L 2 L 1 n

ni

Pi n (1)

0.1

0.095

0.09

0.085

0.08

0.1

0.0907143

0.081875

0.0733333

0.065

Ho-Lee

model rates

with term

structure of

volatilities

0.1430264

0.1267402

0.1300264

0.1098368

0.1135402

0.1170264

0.0927784

0.0967368

0.1003402

0.1040264

0.076018

0.0800784

0.0836368

0.0871402

0.0910264

0.06

0.064018

0.0673784

0.0705368

0.0739402

0.0780264

24

Alternative Arbitrage-free

Interest Rate Modeling

Techniques

techniques

Spot rate model

N-factor model

Lattice model

Continuous time model

Calibrations

25

Alternative Valuation

Algorithms

Backward substitution

Pathwise valuation

monte-carlo

Antithetic, control variate

Structured sampling

26

Models

Heath-Jarrow-Morton model

Brace-Gatarek-Musiela/Jamshidian model

(Market Model)

String model

Affine model

27

Examples of Applications

Mortgage-backed securities

Prepayment models

CMOs

Insurance products

28

Conclusions

Comparing relative valuation and the NPV

model

Imagine the world without relative

valuation

Beyond the Primer:

Identifying the economics of the models

29

References

Ho and Lee (2005) The Oxford Guide to

Financial Modeling Oxford University Press

Excel models (185 models)

www.thomasho.com

Email: tom.ho@thomasho.com

30

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