Value at Risk (VaR) is a tool for measuring a portfolio’s risk.
There are basically 3 methods for calculating the VaR [1] - Historical simulation
- Variance-covariance approach
- Monte Carlo simulation
In this post, we implement the 3 The simulation parameters are as follows, - Portfolio value: $1 Million
- Confidence interval: 95%
- Time horizon: 1 day
- Underlying: SPY
We utilize 5-years daily data of SPY retrieved from Yahoo Finance. The picture below shows the VaR retuned by the Python program. Note that the method presented in this post is suitable for calculating the VaR in a normal market condition. More advanced approaches such as Expected Tail Loss have been developed that can better take into account the tail risk. Follow the link below to download the Python program.
[1] Hull, John C. (2003). Options, Futures, and Other Derivatives. Prentice-Hall Originally Published Here: Value At Risk – Financial Risk Management in Python
0 Comments
Just like any financial derivatives that were initially designed for risk management purposes, interest rate swaps are an effective tool for managing and transferring interest rate risks as long as those risks are well understood. But as banks and financial institutions are constantly trying to invent new financial products to sell to their consumers, sometimes the risks of those products are not well understood and disclosed. This is what happened with the interest rate swap market in New Zealand where banks sold interest rate swaps to farmers in order for them to hedge the fluctuation in the mortgage rates. However, the banks only emphasized the advantages of the interest rate swaps, and they did not discuss the potential downside in detail.
When the financial crisis hit, and the interest rates went down, farmers started losing money. Many were forced to sell their farms, and some of them committed suicide.
The problem is not in the financial derivative itself, but it is that the risks were not well understood and explained to the customers.
Originally Published Here: Another Misuse of Financial Derivatives Convertible debt is a type of loan that can be converted back to stock after some specified future date. When making an investment in convertible debt, both the issuer and investor are clear that there is a possibility of debt being converted into stock in the future. International Account Standard 32 deals with accounting for convertible debt. A convertible debt instrument is an alternative financing solution, normally used by companies to finance their operation or working capital. The peculiar thing about this arrangement is that both parties can be on the same page regarding an eventual conversion of convertible debt into common stock of the company. In other words, both the issuer and the holder can convert the debt into equity at a future date. However, the former (i.e. the forced conversion) is rare, while the latter (conversion by the holder) is more common. Sometimes, it is not easy for the company to issue convertible debt because the shareholder may oppose this management decision. This is due to the fact that upon conversion of the debt to equity, the shareholders’ stock values will decline because of the share dilution. Therefore management needs to pursue by performing a cost-benefit analysis as to why the issuance of convertible debt is beneficial to the company and its shareholders at the same time.
Normally, the company issues the bond at par, but sometimes it can offer a discount to investors in convertible debts as an incentive. For example, Mr. A purchased a convertible bond on January 01, 2020, for $500,000 at $500 each, whereas the par value of the bond is $550. Why has the company offered a discount on the issuance of the bond? It is because investors will be likely to convert their debts into equities.
Debt is senior to equity in terms of payback at times of liquidation. So if an investor is willing to forgo his debt right for equity, then obviously the company has to offer some incentive in order to keep its investment. Moving forward in the above-mentioned example, if the maturity of the bond is December 31, 2024, this means that after 5 years, the investor can convert and the company can reduce its debts leverage and issue its stocks in place.
A company at times is in need of financing, but they don’t want to increase their debt leverage, therefore they offer a discount to investors for investing in their convertible debt instruments. Once the investment has been made, the company can save itself from a debt burden.
Often times it is worthwhile to invest in a company’s stock but for some reason, the investor does not want to invest in equity immediately. Therefore a better way is to go for convertible debt and then convert it into equity at a future date. This way, the investor will be in the position of a shareholder. In addition, as discussed above, the investor can be offered a discount as an incentive for investing in convertible debt.
As both the company and investors have the same understanding that after a defined period of time they can convert the debt into common stocks, therefore as per IAS-32, when accounting for the convertible debt, the company has to recognize the issuance of convertible debts as a compound instrument. Every year the interests accrued on the debt portion of the convertible debt shall be recognized in the profit and loss statement, and at the maturity of that instrument, all the loan shall be converted into equity at par and will be recognized in the capital of the company. Post Source Here: Accounting for Convertible Debt In a previous post, we presented a methodology for pricing European options using a closed-form formula. In this installment, we price these options using a numerical method. Specifically, we will use Monte Carlo simulation. Recall that, - A call option gives the buyer the right, but not the obligation to buy an agreed quantity of the underlying from the seller at a future time for a given price. The payoff of the call option at expiration is
*max(S*_{T}-K,0), - A put option gives the buyer the right, but not the obligation to sell an agreed quantity of the underlying to the seller at a future time for a given price. The payoff of the put option at expiration is
*max(K -S*_{T},0),
where K is the strike price.To price these options, we first simulate the price paths using the following Stochastic Differential Equation: where *S*is the stock price at time_{t}*t,*- σ denotes the stock volatility,
- µ is the drift which equals the risk-free rate, and
*dW*represents the standard normal random variable._{t}
The simulation is carried out until the options’ maturity. We then apply the terminal payoff functions and calculate the mean values of all the payoffs. Finally, we discount the mean values to the present and thus obtain the option values. For a more detailed presentation of the Monte Carlo method, see Reference [1]. The picture below shows the call and put option prices using 100000 simulations. All other parameters are the same as in the previous post. We compare the above results to the ones obtained by using a third-party software and notice that they are in good agreement. In the next installment, we will present a methodology for pricing American options using Monte Carlo simulation.
[1] Glasserman, Paul;
Follow the link below to download the Python program. Post Source Here: Valuing European Options Using Monte Carlo Simulation-Derivative Pricing in Python The Black-Scholes-Merton model is one of the earliest option pricing models that was developed in the late 1960s and published in 1973 [1,2]. The most important concept behind the model is the dynamic hedging of an option portfolio in order to eliminate the market risk. First, a delta-neutral portfolio is constructed, and then it is adjusted to stay delta neutral as the market fluctuates. Finally, we arrive at a Partial-Differential Equation for the value of the option. where *V*denotes the option value at time*t,**S*is the stock price,*r*is the risk-free interest rate and,- σ is the stock volatility.
This equation is also called a In this post, we focus on the implementation of the Black-Scholes-Merton option pricing model in Python. Closed-form formula for European call and put are implemented in a Python code. The picture below shows the prices of the call and put options for the following market parameters: - Stock price: $45
- Strike price: $45
- Time to maturity: 1 year
- Risk-free rate: 2%
- Volatility: 25%
We compare the above results to the ones obtained by using third-party software and notice that they are in good agreement. In the next installment, we will price these options using Monte Carlo simulation.
[1] Black, Fischer; Myron Scholes (1973). [2] Merton, Robert C. (1973). [3] Hull, John C. (2003).
Follow the link below to download the Python program. Originally Published Here: Black-Scholes-Merton Option Pricing Model-Derivative Pricing in Python A derivative is a financial instrument whose price is Although the pricing models differ for each type of derivative, the underlying principle is the same: financial derivatives are priced based on non-arbitrage principle, or the law of one price. ## Forward ContractsA forward contract is a private agreement between two parties giving the buyer an obligation to purchase an asset, and the seller an obligation to sell an asset at a set price at a future point in time. The underlying asset can be anything of value. In order to understand this better, let us look at a simple example. Let us assume that the underlying asset here is a 10 kg bag of apples that have not been harvested yet. Technically, the underlying asset does not even exist, so it has no financial value. However, it is still possible to assign a price to it. Suppose that a farmer enters into a forward contract to sell the 10 kg bag of apples at a price of $20 in 3 months' time when the apples will be harvested. The farmer does this because he fears that the price of apples may go down in the future, resulting in a loss for him. So in order to set off or hedge the potential loss, the farmer enters into a forward contract with a buyer who agrees to buy the 10 kg bag of apples at the $20 price determined today. This means that 3 months from now, the forward contract will be executed at $20 regardless of the price in the future. In this manner both the buyer and seller transfer the risks to each other. Forward contracts are often customized and trade over the counter. ## Future ContractsA futures contract is a legal agreement to buy or sell a particular commodity, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity in order to facilitate trading on an organized exchange. In addition, unlike forwards, the profit and loss of a futures contract is settled daily. Despite the differences, the underlying principles for both futures and forwards are the same. The parties enter into a contract to buy or sell a particular underlying asset at a fixed price in the future, and the value of the contract is determined as the underlying asset is realized. ## Option ContractsAn options contract is an agreement between a buyer and seller that gives the buyer of the option the right but not the obligation to buy or sell a particular asset at a later date at an agreed-upon price. Options contracts are often used in securities, commodities, and real estate transactions. In principle, options are similar to forwards and futures but the difference is its holder has a right, but not an obligation to buy or sell the underlying asset. A call option gives the buyer the right to buy the asset at a predetermined price at or before maturity. A put option allows the holder to sell at a predetermined price at or before expiration. Going back to our original example, suppose that the farmer has bought a put option that allows him to sell apples at $20. Three months later, if the price of 10 kg bag of apples becomes $24, then in this situation the farmer would have the option of not executing the contract at $20 and instead of selling the 10 kg bag of apples at the market price of $24. However, if the price of the apples falls down to $15, then the farmer can exercise the put option and sell the apples at the contractual price of $20.
There are different models for valuing options. The earliest model is called the Black-Scholes option pricing model which provides an analytical, closed-form formula for valuing a European option. The model requires 5 important input parameters: spot price, strike price, volatility, risk-free rate, maturity.
Binomial option model is used to value American style options. The model relies on the assumption that for the next time period, a stock can move up, or down with certain probabilities. The major advantage of the binomial model is that it’s relatively simple. To value an option using this method, a tree of possible values of the underlying assets is built first. Then the option value is determined by calculating its payoffs at maturity and rolling back to time zero. ## SwapsA swap is a derivative contract through which two parties can exchange the cash flows or liabilities from two different financial instruments. The most common type of swap is interest rate swap, however, there exist other types such as commodity and currency swaps. Interest rate swaps are used to manage and transfer interest rate risks. Let’s take a look at an example, a parent company operating in the USA has a subsidiary in Europe. The parent in the USA has to pay a fixed-rate loan in dollars whereas the subsidiary based in Europe has to pay a variable rate loan in Euro. The parent wants to pay a variable rate based on its cash flow situation whereas the subsidiary wants the fixed-rate loan because of the certainty of payments. Thus, both the parent and subsidiary will enter into an interest rate swap where the parent will end up paying the variable-rate euro loan and the subsidiary will end up paying the fixed-rate dollar loan. An interest rate swap can be valued by decomposing it into fixed-rate and floating-rate bonds. Essentially, the value of each leg is determined by calculating the Net Present Value of future cash flows. An alternative way to value an interest rate swap is to view it as a series of Forward Rate Agreements. Article Source Here: Derivative Pricing and Valuation In a previous post, we discussed the risks of Collateralized Loan Obligations, a type of complex credit derivatives. Since then, the trend in securitizing loans is still upward. Nowadays, not only performing loans but also non-performing loans are being securitized and sold to investors. A non-performing loan is a loan that is in default or close to being in default. Depending on the terms of the contract, a loan can become non-performing after being in default for 90 days. Recently, independent.ie reported
Securitization is a proactive measure that allows a financial institution to transfer the risks of a portfolio of non-performing loans.
However, there are many issues associated with managing the risks of these non-performing loans, notably the lack of standard definitions and valuation methodology. A solid regulatory framework should be developed to ensure market transparency and to facilitate risk management. Originally Published Here: Are Collateralized Loan Obligations the New Debt Bombs? Part Two In a previous post, we presented a theoretical framework for pricing convertible bonds and preferred shares. We also provided an example of pricing a convertible bond in Excel. In this installment, we present an example of pricing a convertible bond in Python. Recall that a convertible bond (or preferred share) is a hybrid security, part debt, and part equity. Its valuation is derived from both the level of interest rates and the price of the underlying equity. Several convertible bond pricing approaches are available to value these complex hybrid securities such as Binomial Tree, Partial Differential Equation and Monte Carlo simulation. One of the earliest approaches was the Binomial Tree model originally developed by Goldman Sachs and this model allows for an efficient implementation with high accuracy. The Binomial Tree model is flexible enough to support the implementation of bespoke exotic features such as redemption and conversion by the issuer, lockout periods, conversion and retraction by the shareowner. Details of the hypothetical convertible bond are as follows:
The picture below shows the bond price obtained by using a third-party program. Using the Python program, we obtain a clean price of 113.27 Follow the link below to download the Python program. Article Source Here: Valuing a Convertible Bond-Derivative Pricing in Python As negative interest rates started popping up around the world, quantitative analysts and traders have been asking a mundane but fundamental question: How to price trillions of dollars of financial instruments when their complex pricing models don’t work with negative numbers? Intuitively, we would say that negative interest rates will affect the prices of interest-rate sensitive instruments such as interest rate swaps and swaptions the most. Indeed, Bloomberg recently elaborated:
As far as equity derivatives are concerned, the impact will not be as dramatic as with interest-rate sensitive instruments. However, some subtleties in the mathematical approaches can still have an impact on the accuracy of equity-derivative valuation models.
Specifically, when we price an American call option, we often argue that if the underlying stock pays no dividend, then it’s never optimal to exercise earlier, i.e. the price of an American call option is equal to its European counterpart. To see this, recall that there exists a lower bound for an American call option on a non-dividend paying stock [1]: where
From this equation, it follows that when However, when
[1] J.C. Hull, Article Source Here: How Negative Interest Rates Affect Derivative Pricing Models Investors in South Korea have lost money in a complex derivative linked to constant maturity swap. In search for higher yields, they are also putting money into another complex financial instrument, convertible bonds. Bloomberg recently reported,
This convertible bond has a complex feature, and the regulators are worrying that investors will lose money if they don’t fully understand the financial instrument.
Investing in convertible bonds can add value to a portfolio. However, valuing a convertible bond and managing the risks is not trivial.
Originally Published Here: Are Convertible Bonds Really Attractive? |