Manufacturing and Managing Customer-Driven Derivatives Manufacturing and Managing Customer-Driven Derivatives sheds light on customer-driven derivative products and their manufacturing process, which can prove a complicated topic for even experienced financial practitioners. This authoritative text offers up-to-date knowledge and practices across a broad range of topics that address the entire manufacturing, pricing and risk management process, including practical knowledge and industrial best practices. This resource blends quantitative and business perspectives to provide an in-depth understanding of the derivative risk management skills that are necessary to adopt in the competitive financial industry. Manufacturing and managing customer-driven derivative products have become more complex due to macro factors such as the multi-curve environments triggered by the recent financial crises, stricter regulatory requirements of consistent modelling and managing frameworks, and the need for risk/reward optimisation. * Explore the fundamental components of the derivatives business, including equity derivatives, interest rates derivatives, real estate derivatives, and real life derivatives, etc. * Examine the life cycle of manufacturing derivative products and practical pricing models * Deep dive into a wide range of customer-driven structured derivative products, their investment or hedging payoff features and associated risk exposures * Examine the implications of changing regulatory standards, which can increase costs in the banking sector * Discover practical yet sophisticated product analysis, quantitative modeling, infrastructure integration, risk analysis, and hedging analysis * Gain insight on how banks should handle complex derivatives products Manufacturing and Managing Customer-Driven Derivatives is an essential guide for quants, structurers, derivatives traders, risk managers, business executives, insurance industry professionals, hedge fund managers, academic lecturers, and financial math students who are interested in looking at the bigger picture of the manufacturing, pricing and risk management process of customer-driven derivative transactions.
Preface xiii Acknowledgments xv About the Author xvii PART I Overview of Customer-driven Derivative Business 1 CHAPTER 1 Evolving Derivative Business Environment 3 Customer-driven Derivative Product Categories 3 Lessons in Derivatives and Crises 4 Regulations Affecting Derivative Business 7 Structured Derivative Products Geographic Features 11 CHAPTER 2 Pillars in Structured Derivative Business 21 Derivative Business Value Chain 21 Model and Product Development Process 22 Product Issuance and Wrappers 31 Product Distribution 35 CHAPTER 3 Financial Risk Management, Basel III and Beyond 39 Risk Measures and Financial Rule Books 39 Basel III Technical Requirements 41 Internal Model Method (IMM) 48 Beyond Basel III 55 PART II Equity Derivatives 59 CHAPTER 4 Equity Derivatives Market Features 61 Equity Index Underlyings 61 Discrete Dividends 61 Option Settlement Delay 68 Quanto Effect 70 Future Versus Forward 72 Implied Volatility Surface 74 CHAPTER 5 Black Scholes Paradigm 87 Basic Modelling Framework 87 Asian Options 93 Basket Options 100 Dividend Futures and Options 103 American Options 106 Barrier Options 110 Lookback and Hindsight Options 113 Volatility Smile/Skew Dynamics Impact on Hedging 117 CHAPTER 6 Local Volatility Framework 123 Local Volatility Stripper 123 Local Volatility PDE Solver 127 Local Volatility Monte Carlo 132 Local Volatility to Implied Volatility 138 Practical Issues With Local Volatility 142 CHAPTER 7 Stochastic Local Volatility Framework 145 Stochastic Volatility Models 145 SLV Model Formulation 147 SLV Numerical Implementation 150 SLV Numerical Results 154 SLV in Practice 161 CHAPTER 8 Equity-Linked Structured Products 163 General Payoff Category 163 Features of Important Structured Product Categories 168 Barrier Reverse Convertibles 183 Constant Proportion Portfolio Insurance (CPPI) 187 Risks During Retail Issuance Period 193 CHAPTER 9 Basket Option Analysis 197 Basket Option Risks 197 Copula Pricing Models 198 Historic Basket Volatility Surfaces 213 Implied Basket Volatility Surfaces 217 Copula Applications 224 PART III Interest Rate Derivatives 227 CHAPTER 10 Multi-Curve Environment and Yield Curve Stripping 229 Multi-Curve Environment 229 Yield Curve Stripping 237 Collateral Impacts 248 Multi-Curve Multi-Facet Reality 252 CHAPTER 11 Vanilla Interest Rate Options 255 Martingale Pricing Principle 255 Cap/Floor 258 European Swaption and SABR 274 Risk Sensitivities 286 CHAPTER 12 Practical Interest Rate Derivative Models 293 Key Model Categories 293 Linear Gauss Markov Model 295 Libor Market Model 303 Extended Cheyette Model 312 Local Volatility Model 318 CHAPTER 13 CMS Replication and CMS Spread Options 343 CMS Convexity 343 CMS Replication 344 CMS Calibration 350 CMS Spread Option Pricing Framework 356 Copula Pricing with Full Market Marginal Distributions 362 CHAPTER 14 Interest Rate Derivative Products 375 Product Design and Product Risks 375 Bermudan Swaption 381 Callable Products 387 Other Important Products 392 PART IV Real-Life Options and Derivatives 399 CHAPTER 15 Long-dated FX Volatility and Hybrid Risks 401 FX Volatility Surface 401 Extrapolating FX Volatility Term Structure to Long End 403 Extrapolating FX Volatility Smile to Long End 407 Hybrid Optionality 410 PRDC Hybrid Risks 413 CHAPTER 16 Portfolio CVA: Efficient Numerical Techniques 419 CVA Valuation Implementation Framework 420 Numerical Techniques in Portfolio CVA Valuation 420 Grid Monte Carlo for CVA 422 GMC Implementation Example 425 GMC in Practice 432 CHAPTER 17 Contingent Convertibles (CoCo) 435 CoCo Features 435 CoCo Categories 436 CoCo Risk Factors 438 Indirect Modelling Approaches 439 Direct Modelling Approaches 442 CHAPTER 18 Variable Annuity Products 451 Key VA Product Types 453 Major Risk Factors in VA Products 456 Hybrid Pricing Models for VA Products 458 Practicalities of Handling Long-dated VA Products 466 Importance of Understanding VA Risks 469 CHAPTER 19 Interest Rate Optionality in Fixed-Rate Mortgage 473 Prepayment Optionality 473 Prepayment Risk Characteristics 479 Early Redemption Charge 486 Applying Option-Based Prepayment Technique 488 CHAPTER 20 Real Estate Derivatives 491 Equity Release Scheme and Related Derivatives 491 Mortality in Derivatives Pricing 492 Reversion Derivatives Products 497 Real Estate Portfolio Derivatives 501 Property-Linked Roll-Up Mortgage 507 HPI Retail Products 512 APPENDIX A: PRODUCT OF TWO CALLS 515 Decomposition 515 Three Key Integrals 516 Analytical Formula 518 BIBLIOGRAPHY 521 INDEX 531
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