An interest rate swap (IRS) is a financial derivative instrument that involves an exchange of a fixed interest rate for a floating interest rate. More specifically, An interest rate swap’s (IRS’s) effective description is a derivative contract, agreed between two counterparties, which specifies the nature of an exchange of payments benchmarked against an interest rate…
Read More Interest Rate Swap-Derivative Pricing in ExcelIn a previous post, we provided an example of pricing American options using an analytical approximation. Such a pricing model is fast and accurate enough for risk management purposes. However, sometimes more accurate results are required. For this purpose, the binomial (lattice) model can be used. Wikipedia describes the binomial tree model as follows, In…
Read More Valuing an American Option Using Binomial Tree-Derivative Pricing in ExcelIn the previous installment, we presented a concrete example of pricing a European option. In this follow-up post we are going to provide an example of valuing American options. The key difference between American and European options relates to when the options can be exercised: A European option may be exercised only at the expiration…
Read More Valuing an American Option-Derivative Pricing in ExcelAn option is a financial contract that gives you a right, but not an obligation to buy or sell an underlying at a future time and at a pre-determined price. Specifically, … an option is a contract which gives the buyer (the owner or holder of the option) the right, but not the obligation, to…
Read More Valuing a European Option-Derivative Pricing in ExcelLast year, in a post entitled Credit Derivatives-Is This Time Different we wrote about credit derivatives and their potential impact on the markets. Since then, they have started attracting more and more attention. For example, Bloomberg recently reported that collateralized loan obligations (CLO), a type of complex credit derivatives, are becoming a favorite financing vehicle…
Read More Are Collateralized Loan Obligations the New Debt Bombs?The overnight index swap (OIS) has come into the spotlight recently, due to the widening of the Libor-OIS spread. For example, the Economist recently reported: WATCHING financial markets can be like watching a horror film. A character walks into the darkness alone. A floorboard creaks. The latest spooky sign is the spread between the three-month…
Read More Overnight Index Swap DiscountingThe volatility index was created more than 30 years ago. Since then it has become a favorite tool for both speculation and risk management. There is now strong evidence that VIX futures and related exchange-traded products are changing the market dynamics. Specifically, in the early days of the VIX, the cash market led the futures.…
Read More What Do Creators of the VIX Think of Volatility?Credit derivatives, the types of complex financial instruments that were responsible for the 2008-09 Global Financial Crisis, are back to the news. Two months ago, Frances Schwartzkopff of Bloomberg reported, A complex credit product that regulators are still trying to get their heads around is proving popular with some big institutional investors in Europe. The…
Read More Credit Derivatives-Is This Time Different?Last Wednesday saw a huge increase, in percentage terms, of the volatility indices. The 1M spot VIX increased by 46%, while the underlying SPX index decreased by only -1.8%. As discussed in our previous post entitled Is Volatility of Volatility Increasing?, such a big percentage change in the VIX associated with a “normal” down day…
Read More What Caused the Increase in Volatility of Volatility?In a previous post, we examined the relationship between the Credit Default Swap (CDS) and equity volatility, and argued that there is a strong correlation between them. But like any relationship in financial markets, this one can break down and divergence can happen. For instance, last month we noticed that CDS in Asia and Australia…
Read More Divergence Between Credit Default Swap and Equity Volatility