Rethinking Valuation and Pricing Models

Editor’s Disclaimers

Foreword

Editors

Contributors

1. The Effectiveness of Option Pricing Models During Financial Crises

1.1 Introduction

1.2 Methodology

1.3 Data

1.4 Results

1.5 Concluding Remarks

References

2. Taking Collateral into Account

2.1 Introduction

2.2 Notations and Problem

2.3 Black–Scholes Partial Differential Equation in the Presence of Collateral

2.4 Collateral Discount Curve Bootstrapping

2.5 Pricing and Bootstrapping of the IR Vanilla Swap Term Structure

2.6 European Swaption Pricing Framework

2.7 Collateral Effect and Term-Structure Models

2.8 Conclusion

References

3. Scenario Analysis in Charge of Model Selection

3.1 Introduction to Model Risk

3.2 Classical Calibration Procedure

3.3 Processes, Dynamics and Model Definition

3.4 Importance of Risk Premia

3.5 Equity Volatility Modeling

3.6 Foreign Exchange Volatility Modeling

3.7 Conclusions

Note

References

4. An “Economical” Pricing Model for Hybrid Products

4.1 Introduction

4.2 Pricing Convertible Bonds

4.3 Two-Factor Numerical Procedure

4.4 Default Risk

4.5 Pricing Convertible Bonds Subject to Interest Rate Risk and Default Risk

4.6 Conclusion

Note

References

5. Credit Valuation Adjustments– Mathematical Foundations, Practical Implementation and Wrong Way Risks

5.1 Introduction

5.2 Mathematical Foundations of CVA

5.3 Practical Implementation: Issues and (Wrong Way) Risks

5.4 Model Risks in CVA Calculation

5.5 Summary and Prospects

Notes

References

6. Counterparty Credit Risk and Credit Valuation Adjustments (CVAs) for Interest Rate Derivatives–Current Challenges for CVA Desks

6.1 Introduction

6.2 Traditional Counterparty Risk Management Approaches

6.3 Modeling Credit Exposure and Pricing CCR

6.4 New Challenges and Reactions

6.5 Practical Problems

6.6 Conclusions and Lessons Learned

References

7. Designing a Counterparty Risk Management Infrastructure for Derivatives

7.1 Need for an Integrated Counterparty Risk Management

7.2 Building Blocks for an Adequate Infrastructure

7.3 General Computing Approach

7.4 Trade Assessment

Notes

References

8. A Jump–Diffusion Nominal Short Rate Model

8.1 Introduction

8.2 The Economy

8.3 Equilibrium Interest Rates and Monetary Policy

8.4 A Nominal Interest Rate Model

8.5 Conclusion

Appendix: Proof of Proposition 2

Acknowledgments

References

9. The Widening of the Basis: New Market Formulas for Swaps, Caps and Swaptions

9.1 Introduction

9.2 Assumptions on the Discount Curve

9.3 Fra Rates: Definition and Pricing

9.4 IRS Valuation

9.5 Pricing of Caplets and Swaptions

9.6 Conclusions

References

10. The Financial Crisis and the Credit Derivatives Pricing Models

10.1 Introduction

10.2 Brief Description of Credit Derivatives

10.3 CDO Pricing Models and the Financial Crisis

10.4 Conclusion: Risk Premia and Asset Pricing Models

References

11. Industry Valuation-Driven Earnings Management

11.1 Introduction

11.2 Literature Review and Hypotheses Development

11.3 Data and Variables

11.4 Empirical Tests and Results

11.5 Conclusion

References

12. Valuation of Young Growth Firms and Firms in Emerging Economies

12.1 Introduction

12.2 The Basic Problem

12.3 Data and Numerical Procedure

12.4 Results

12.5 Conclusion

References

13. Towards a Replicating Market Model for the US Oil and Gas Sector

13.1 Introduction

13.2 Model

13.3 Data

13.4 Preliminary Analysis and Results

13.5 Main Results

13.6 Conclusion

References

14. Measuring Systemic Risk from Country Fundamentals: A Data Mining Approach

14.1 Introduction

14.2 Financial Crises and Leading Indicators

14.3 Financial Crises and Risk Signals

14.4 Analysis and Results

14.5 Conclusions

References

15. Computing Reliable Default Probabilities in Turbulent Times

15.1 Introduction

15.2 Brief Review of the KMV-Merton Model

15.3 Brief Review of the ZPP Model

15.4 Empirical Analysis

15.5 Conclusion

References

16. Discount Rates, Default Risk and Asset Pricing in a Regime Change Model

16.1 Introduction

16.2 Proxy for Discount Rates from a Regime Change Model

16.3 Leveraging, Risk Premia and Asset Prices using Brownian Motions

16.4 Discount Rates, Risk Premia and Asset Prices in a Dynamic Model

16.5 Results of the Numerical Study

16.6 Conclusions

References

17. A Review of Market Risk Measures and Computation Techniques

17.1 Introduction

17.2 Market Risk, Portfolio Value and Returns

17.3 Market Risk Factors and Portfolio Value

17.4 Major Market Risk Measures and Their Computation Methods

17.5 Backtesting of Market Risk Computation Methods

17.6 Conclusion

Appendix: Stochastic Processes Used in Finance

References

18. High-Frequency Performance of Value at Risk and Expected Shortfall: Evidence from ISE30 Index Futures

18.1 Introduction

18.2 Literature

18.3 Market and Data

18.4 Methodology

18.5 Empirical Results

18.6 Conclusion

Notes

References

19. A Copula Approach to Dependence Structure in Petroleum Markets

19.1 Introduction

19.2 Empirical Methodology

19.3 Data and Results

19.4 Conclusion

References

20. Mistakes in the Market Approach to Correlation: A Lesson For Future Stress-Testing

20.1 Introduction

20.2 From Flat Correlation towards a Realistic Approach

20.3 Payoff Stress and the Liquidity Mistake

20.4 Testing with Historical Scenarios and the Concentration Mistake

20.5 Lessons for Future Stress-Testing

Notes

References

21. On Correlations between a Contract and Portfolio and Internal Capital Alliocation

21.1 Introduction

21.2 Adding a Deal to a Company Portfolio

21.3 Example: Correlated Power-Law Distributions

21.4 Formula for the Quantile Shift

21.5 Quantile Shift Under Secondary Uncertainty

21.6 Capital Allocation by Average Shortfall

21.7 Evolution of Quantiles in Portfolio Aggregation

21.8 Static and Dynamic Capital Allocation

21.9 Conclusion

References

22. A Maximum Entropy Approach to the Measurement of Event Risk

22.1 Introduction

22.2 Theory and Methods

22.3 Empirical Analysis

22.4 Conclusions

References

23. Quantifying the Unquantifiable: Risks Not in Value at Risk

23.1 Introduction and Motivation

23.2 Regulatory Developments and Requirements

23.3 Examples of Different Products and Risk Factors

23.4 Approaches to Quantifying Risks not in VaR

23.5 Treatment within the Internal Capital Adequacy Process

23.6 Conclusion and Outlook

Notes

References

24. Active Portfolio Construction When Risk and Alpha Factors are Misaligned

24.1 Introduction

24.2 Framework for Active Portfolio Construction

24.3 Misalignment of Risk and Alpha Models

24.4 Portfolio Optimization with Alpha Decomposition

24.5 Mitigation for Alpha and Risk Factor Misalignment

24.6 Case Studies

24.7 Conclusion

References

25. Market Volatility, Optimal Portfolios and Naive Asset Allocations

25.1 Introduction

25.2 Mean and Variance Forecasts

25.3 Investment Sets

25.4 Performance Evaluation

25.5 Results from the Full Sample-Analysis

25.6 Rolling Performance Evaluation and Market Volatility

25.7 Conclusions

References

26. Hedging Strategies with Variable Purchase Options

26.1 Introduction

26.2 Description of the Product

26.3 Pricing and Hedging Bounded VPOs

26.4 Conclusions

Acknowledgments

References

27. Asset Selection Using a Factor Model and Data Envelopment Analysis– A Quantile Regression Approach

27.1 Introduction

27.3 Data and Methodology

27.4 Discussion of Results

27.5 Conclusion

References

28. Tail Risk Reduction Strategies

28.1 Introduction

28.2 Data and Methodology

28.3 Empirical Results

28.4 Conclusion

References

29. Identification and Valuation Implications of Financial Market Spirals

29.1 Introduction

29.2 Literature Review

29.3 Data and Descriptive Statistics

29.4 Results

29.5 Conclusion

References

30. A Rating-Based Approach to Pricing Sovereign Credit Risk

30.1 Introduction

30.2 Literature Review and Methodology

30.3 Dataset

30.4 Transition Matrices Estimation

30.5 Asset Pricing

30.6 Conclusions

Notes

References

31. Optimal Portfolio Choice, Derivatives and Event Risk

31.1 Introduction

31.2 Model

31.3 Parameter Estimation

31.4 Optimal Portfolios

31.5 Conclusion

References

32. Valuation and Pricing Concepts in Accounting and Banking Regulation

32.1 Introduction

32.2 Accounting

32.3 Banking Regulation

32.4 Critical Assessment

32.5 Conclusion

References

33. Regulation, Regulatory Uncertainty and the Stock Market: The Case of Short Sale Bans

33.1 Introduction

33.2 Classical Models: Theoretical Models of Constraining Short Sales

33.3 Empirical Evidence Prior to the 2008 Financial Crisis

33.4 Empirical Evidence from and Since the Financial Crisis of 2008

33.5 Future Challenges

References

34. Quantitative Easing, Financial Risk and Portfolio Diversification

34.1 Introduction

34.2 Financial Markets and Macro-Finance Indicators Before and After 2006

34.3 Risk Aversion, Risk Premia and the Discounting Process

34.4 Concluding Remarks

References

35. Revisiting Interest Rate Pricing Models from an Indian Perspective: Lessons and Challenges

35.1 Introduction

35.2 Success and Lessons

35.3 Challenges

35.4 Conclusion

References

36. Investment Opportunities in Australia’s Healthcare Stock Markets After the Recent Global Financial Crisis

36.1 Introduction

36.2 Patterned Vecm Modeling and Causality Measurement

36.3 Data and Empirical Vecm Findings

36.4 Conclusion

References

37. Predicting ASX Health Care Stock Index Movements After the Recent Financial Crisis Using Patterned Neural Networks

37.1 Introduction

37.2 Construction of a Polynomial Neural Networks Using a Patterned VAR

37.3 Data and Empirical Sparse-Patterned VAR Findings

37.4 Conclusion

References

Index