Learning Curve

Hedge funds have traditionally used repo agreements to short securities and gain short-term exposure to illiquid assets but increasingly are starting to use total rate of return swaps instead. Frederik Barnekow, head of securities finance at SEB Merchant Bank in Stockholm, attributes this to the growing sophistication of hedge funds. Stuart Pyott, equity derivatives trader at Schroder Salomon Smith Barney in London, added that the demand for swaps has grown over the last year because they have become more liquid, standardized and competitively priced.

The market abuse regime in the U.K. is Part VIII of the Financial Services and Markets Act 2000, due to come into force on Dec. 1 and is a new concept for English financial regulatory law. The fundamental concept of the regime is that users of a U.K. regulated market have a positive duty to ensure that they do not, by their acts, statements, conduct or omissions, impede the efficient operation of that market. This duty extends to persons who, although they do not use the market themselves, benefit from it--thus derivatives traders should not act in such a way as to damage the markets in the underlying securities by reference to which they price their derivatives. This duty is loosely equivalent to a duty of care and a breach of the duty is punishable by a fine. Section 118 of the act sets out that behavior is to be treated as market abuse if it is behavior which is "likely to be regarded by a regular user of that market who is aware of the behavior as a failure on the part of the person or persons concerned to observe the standard of behavior reasonably expected of a person in his or their position in relation to the market". This is an "objective intent" test--that is, the question of culpability is determined not by reference to what the person doing the act intended, but by reference to what an experienced external observer would have concluded that that person's intentions were. This has the interesting side effect that market abuse can be perpetrated entirely inadvertently--even where a person can prove that they had no intention of abusing a market, if the FSA can show that a reasonable market user would have objected to the conduct, then the conduct is prima facie market abuse. Note also that where a transaction between two parties to an over-the-counter derivative has the effect of abusing a market in a reference obligation, the question of what the counterparts to the derivative should have known and thought and what they must have intended will be assessed by reference to a regular user of the underlying market, despite the fact that neither of the parties to the OTC derivative may be users of that market at all. The point here is that if you do things which may have the effect of abusing markets, the FSA takes the view that it is up to you to educate yourself as to the customs and practices of those markets.

Despite the high exposure of businesses to rainfall risk most weather derivatives that have been traded have been based on a temperature indices. Nevertheless many end users, such as farmers or hydroelectric generators, are sensitive to rainfall magnitude and frequency. The consequences of too much or not enough rain are spread widely and, directly or indirectly, we all suffer from abnormal rainfall magnitudes.

China's B share markets have been the best performing market indices in the world so far this year with the Shanghai and Shenzhen indices having gained more than 80% and 100% respectively. This effect was primarily a result of structural changes in the market.

The first swap agreement took place between IBM and the World Bank in the early 1980s. Since then sophisticated products have been developed to meet the needs of capital markets players searching for higher returns for investors and more efficient hedging tools as well as offering new financing means for international companies. In order to handle these new complex products and to manage their risk, a range of pricing models have been introduced over the last few years.

Introduction

Introduction

The aim of this Learning Curve is to explain the behaviour of a particularly interesting kind of barrier option, the Parisian, and to focus on its use in structuring exotic equity derivatives products.

In 1952 Harry Markowitz showed that the most revelant risk for an investor is generally not the risk of any one investment by itself but rather it is that of the aggregate portfolio of investments. As a result of this seminal work the standard deviation of this aggregate portfolio's return, or of its excess return relative to a benchmark, was for many years the principle measure of investment risk. It was an essential component of the Nobel prize-winning theory of asset pricing by William Sharpe. It was also a key building block of Stephen Ross' arbitrage pricing theory. Value at Risk or VaR has recently supplanted the standard deviation as the preferred measure of risk. VaR can often be interpreted as a multiple of the standard deviation assuming that a portfolio's returns follow a normal, or log normal, probability distribution.

Unlike vanilla interest-rate swap prices, constant maturity swap prices depend on volatility. This Learning Curve reviews the key points in CMS swap pricing and highlights the impact that the interest rate volatility smile can have in pricing.

This week's Learning Curve covers pricing model application, namely calibration of market models to caps and swaptions, closed form solutions useful for calibration and pricing of Bermudan options with Monte Carlo in the context of the market models. Calibration To Caps & Swaptions

This is the first article in a two-part series looking at the characteristics and applications of market models, and their advantage over traditional approaches in pricing interest-rate derivatives. This article reviews the literature and covers the relationship between the well-known Heath, Jarrowand Morton(HJM) approach and the market models approach. Next week's Learning Curve will examine application issues, namely the calibration of the market models to caps and swaptions, closed form solutions useful for calibration and pricing of Bermudan options with Monte Carlo in the context of the market models.