Friday, December 30, 2005

Interest raate derivatives

Derivatives : Equity derivatives or Interest rate derivatives
Of these two interest rate derivatives are difficult to price due to theier dependence on full term structure of interest rate. Unlike equity,indicies,commodities derivatives , interest rate derivatives have the whole term sturcutre of interest ratee as "underling asset " .

INterest rate derivatives can be divided into two parts : One those which depends on government issued bonds (Government debt security instruments) and second category is Money market instruments (depends on LIBOR rate)
Example of Givernment Debt Security insturments :
1.Options on Tresuries
2.Forward contract on tresuries/gilts
3.Futures on Teasuries/Gilts
Example of Money Market Instruments :
1. Eurodollar futures (base don 3 month LIBOR)
2. Short sterling futures
3. Interest rate swaps
4. cap rate agreements (higher limit on interest rate)
5. Floors (lower limit on interest rate)
6. Collars (Both Higher and Lower limit)

Saturday, October 22, 2005

Trivial but very important

Yesterday we were working on an assignment problem on monte carlo simulation. In this we had to calculate the Stock price by simulation and then call and put option price. And later on find the 95% VaR on portfolio of stock and option. Now what was trivial thing . We were not getting the correct answers and suddenly someone saw that we had used riskfree rate in the stock price modeling not the mu . And then the discussion started that according to risk neutral world Stock price should have riskfree rate in the GBM equation . And all were thinking that wether it should be mu or riskfree rate. Though its very obvious that we should use mu(mean) not the riskfree rate in mdeling the stock price but sometimes you get confused. So once again I want to put down the same . You use riskfree rate in modelingin options only reason because you already have mu in Stock price . That is the risk free world. Not that you use riskfree rate in Stock price . Had that been the case all stocks would have same drift and just different volatility . That only means that High growth companys stock would never rise which have high mean (expected growth rate).

Sunday, October 09, 2005

Todays Digest

Know your Jargon:
Risk-neutral measure : Risk-neutral measure is a probability measure in which todays fair price of a derivatice is equal to the discounted value of future payoff of the derivative.
Risk-neutral world: A world where investors are assumed to require no extra return for bearing risks.

Links :
http://en.wikipedia.org/wiki/Risk-neutral_measure
Article explaining the risk neutral dilemma :
Snippet:
Investor risk preferences are not irrelevant to the absolute price of the derivative. They are irrelevant to the relative price of the derivative. By relative price, we mean the price of the derivative in relationship to the price of the underlying asset. In other words, the mathematical relationship between the derivative and its underlying asset is invariant to the risk preferences of investors who hold the asset

News:
1. China is taking the lead in Research and Development as well. Read this article It says that China will catch up EU by 2010 in R7D spending partly due to investment by european private companiese moving eastward and partially due to China's policy.

Risk Neutral World

Risk-Neutral valuation is the most important but still most confusing topic. I was pretty surprised when our professor derived the Black-Scholes-Merton differential equation for option pricing. There was no expected return terms in the equation instead there was risk free interest rate. Then I was introduced to the world of Risk-Neutral world. So what is this risk-neutral world. When you are pricing derivatives you assume that investors are risk neutral. It means that the value of derivative doesn't depend upon the risk preference of the investor. To find the value of any derivative you can assume a risk neutral world and then calculate the expected payoff at the expiration time and then discount it using risk free rate. Now the question is why should this work.
Aren't people looking for some kind of premium to take some risk. The answer is yes. In real world, you can't expect people to be risk neutral. You need to pay more for risky assets. Then does it mean that Balck Scholes equation is wrong. What is the catch???
Answer is risk neutral valuation is just a tool to find the value of option. The investors aren't isk neutral. Actually the price of derivative depends upon its stock value. And the stock price itself contains the risk information. So if the stock is risky , its value will fluctuate accordingly and the derivative price is proportional to stock price and hence you dont get mu factor in the derivative prices.
Thumb Rule : You can safely use risk neutral valuation tool. It simplifies the derivative world.

One more thing: When you move from risk neutral world to real world two things happen. The expected growth rate in the stock price changes and the discount rate that must be used for any payoffs from the derivative changes. These two changes always offset each other.

Note: Though putting down the BS equation would have been a better idea but then I would have to used equation editor and then paste it here as an image. I wish blogger provided equation editor as well :-)

Friday, October 07, 2005

Daily diet of Financial Engineer

If you want to be a financial engineer(sometimes called as quant or rocket scientists!) you should have these websites bookmarked:
Finance jargons :
1. www.riskglossary.com
2. www.wilmott.com
Basics on finance:
www.investopedia.com
http://en.wikipedia.org
News:
www.bloomberg.com
http://finance.yahoo.com
www.economist.com
Blogs:
http://financialbulls.blogspot.com/
Magzines(paid):
www.wsj.com
Forums:
http://hbswk.hbs.edu/topic.jhtml?t=finance

I will put all these on the side bar so that you can navigate from here to wherever you want, This blog can serve as a portal (single point of access for all financial news and forums). For techy you call it as a portal for wall street people it is a market where you can get whatever you want. Its a two way trade you come to my blog and you get knowledge and I get publicity . Assuming all of you people are rational and want to spread knowledge by telling it to others as well.

Wednesday, October 05, 2005

Birth of Financopedia

I have been writing blog for last few months. With a few months of experience I have realised that I should keep separate blogs for my personal life happenings and technical stuff. Hence, the idea of writing blog on finance emerged.

So,what will be the content of this blog :

1. Similar to "A word a day" it will have "Financial term of the day"
2. Some content from my daily readings (I read finance books rather mathematical finance stuff)
3. Some links to good market news , articles etc .
4. Some gratis advice on financial engineering related job market

Who should read this :
Anyone interested in knowing about financial market . But it is more suitable for students and beginners in finance.

Why:
1. I myself am a beginner so you wont be bombarded with high sounding words and left puzzled after reading my blog
2. I am a student. I wont disclose more about myself.
3. Follow this blog for a week and you won't ask this again :-)

Anonymous (I am looking for some good names till then my signature remains this)