Financial market becomes more complex: volatile market, sophisticated product, and increasing regulation. Traders rely on market
data and valuation tools to compute fair value and risk in order to be successful in this challenge landscape.
To price an option, one needs implied volatility beside yield curve. An implied volatility is the volatility implied by the market
price of an option based on the Black-Scholes option pricing model. The pricing accuracy and pricing performance of option models
crucially depends on absence of arbitrage in the implied volatility surface: an input implied volatility surface that is not
arbitrage-free invariably results in negative transition probabilities and/ or negative volatilities, and ultimately,
into mispricings.
Default Greek Test
We test default greeks by setting the default time of the perturbed obligor to be the valuation date when the present value of each tranche is calculated, no matter when that obligor defaults in the generated Monte Carlo (MC) scenarios. Compared with other models, the implementation of Scenario Manager model is simple, direct, and efficient. However, the joint default events generated in the MC scenarios remain unchanged, which is an approximation of the realistic situation.
Credit Default Swap Option
The European credit default swap option (CDSO) valuation model is employed to price an option that grants its holder the right, but not the obligation, to enter into a Credit Default Swap (CDS) at some future point in time. The premium to be paid on this forward-start CDS is fixed in advance at some strike level. If the reference entity should default before the forward-start date, the contract is in null and no payments are made.
Bermudan Swaption
A Bermudan swaption is an option that gives the buyer the right but not the obligation to enter into a swap at certain pre-defined exercise times. The underlying swap of the Bermudan swaption has two legs: a payer leg and a receiver leg. Each of the legs can pay a fixed rate, Libor or CMS rate.
Bermudan Swaption Introduction
Monte Carlo Multi-factor Short Rate Model
The model assumes that short rates at reset dates are lognormally distributed; the short rate at a reset time arises as the limiting spot value from a corresponding forward rate process, which is a geometric Brownian motion with drift. The short rate model is, by construction, arbitrage free, and numerical test results bear this out.