Learning Curve

One of the least-understood aspects of option pricing is how to account for holidays and weekends when looking at short-dated option prices. Intuitively options have low premiums if there is a smaller window of opportunity to extract value from the gamma. The question is: how do traders calculate this exactly?

The pricing of structured finance instruments is a major issue in risk management and the more complicated the instruments the more important advanced numerical pricing schemes become. In this article, we concentrate on schemes for financial models which lead to partial differential equations. This covers a wide range of models, such as Black-Scholes, certain models of stochastic volatility and the wide range of one or more factor short-rate models, such as Hull-White and Black-Karasinski. Green´s Functions & Adaptive Integration

The delta of an option is frequently considered to be the same as the probability that an option will be exercised, i.e., the probability that the option will be in the money at maturity. There is, however, a difference, especially when it comes to long-dated options on volatile stocks.

The economic crisis of 1998 left the Russian financial markets in shambles. One of the areas most affected was the young yet, at the time, sprawling derivatives market. In the aftermath of the crisis, courts declared non-deliverable forwards to be a form of gambling--thereby negating judicial protection of claims. This made it possible for Russian parties to international derivatives contracts, especially banks, to refuse settlement without having to face the consequences. The following article addresses what has and has not changed since 1998 and describes the current practice of derivatives trading in Russia. It then points out current promising developments, and discusses a likely future scenario.

Investors rarely hedge against inflation, thinking the days of hyperinflation are long gone. But inflation can still make serious inroads into an investor's profit. For example, investors buying five-year U.S. government bonds will see real returns fall from barely above 1% to zero should inflation remain at 3%, instead of returning to 1.7%, predicted by the market.

What Is A One-Touch Option? Internationally active market participants are always subject to changing foreign exchange rates and hedge their exposure by trading an immense variety of options worldwide.

Many derivatives contracts, including the 1992 and 2002 International Swaps and Derivatives Association Master Agreement, do not include a severability clause, which addresses the enforceability of a contract, even though these clauses are usually in commercial contracts. The questions relating to severability are complex, and require careful analysis in the context of any particular derivatives transaction. This article looks at some of the situations, under both English and New York law, in which it may be advisable to consider including a severability clause. ISDA & The Single Agreement Concept

Credit market participants often follow stock prices to get some direction on credit-default swap pricing. Although there is extensive research on swap pricing, it is hard to find explicit examples of how to compute a simple relationship between the two. There are two popular approaches to modeling credit risky instruments, the structural approach and the reduced-form approach. The structural approach treats corporate liabilities as contingent claims on the issuer's assets. Assuming a simple capital structure composed of one zero-coupon bond and a layer of equity, an event of default occurs when the firm's asset value falls below the face value of the zero-coupon bond at maturity. Equity is equivalent to a call option on the assets of the firm, whose strike is equal to the face value of the debt.

This article focuses on the relationship between spot and risk reversals. Using five reference currency pairs chosen for the liquidity of their out-of-the-money options we investigate potential causal links between spot and risk reversals. While a causal link from risk reversals to spot cannot be entirely ruled out in some instances, the relationship appears to be very weak, whereas there is strong evidence supporting a causal link from spot to risk reversals. Consequently, charts showing spot versus risk reversals should be interpreted with caution, bearing in mind that spot is the leading force.

The last 30 years has seen the successful development of mathematical models for financial equity investing. Indeed the Black-Scholes-Merton theory, with its consequent formulas, has changed the way business worldwide handles questions of risk. Nevertheless, as currently used, the models still represent a crude approximation of what is actually going on, and improvements of the models can lead to an edge for an investor. This Learning Curve discusses the overlooked issue of liquidity risk. Economists classify risk into five rubrics:

A recent decision by a U.S. district court over credit derivatives transactions raises the possibility that the duty of a broker-dealer to its customer or counterpart may be expanded based on the market professional's "unique or special expertise"--without regard to the other party's level of sophistication. This article examines how the decision may affect the obligations of a broker-dealer or other market professional to its customer or counterpart beyond, and notwithstanding, the documentation intended to govern their relationship.