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Rethinking Valuation and Pricing Models

Book Description

It is widely acknowledged that many financial modelling techniques failed during the financial crisis, and in our post-crisis environment many techniques are being reconsidered.  This single volume provides a guide to lessons learned for practitioners and a reference for academics.  Including reviews of traditional approaches, real examples, and case studies, contributors consider portfolio theory; methods for valuing equities and equity derivatives, interest rate derivatives, and hybrid products; and techniques for calculating risks and implementing investment strategies.  Describing new approaches without losing sight of their classical antecedents, this collection of original articles presents a timely perspective on our post-crisis paradigm.

  • Highlights pre-crisis best classical practices, identifies post-crisis key issues, and examines emerging approaches to solving those issues
  • Singles out key factors one must consider when valuing or calculating risks in the post-crisis environment
  • Presents material in a homogenous, practical, clear, and not overly technical manner

Table of Contents

  1. Cover image
  2. Title page
  3. Table of Contents
  4. Editor’s Disclaimers
  5. Copyright
  6. Foreword
  7. Editors
  8. Contributors
  9. 1. The Effectiveness of Option Pricing Models During Financial Crises
    1. 1.1 Introduction
    2. 1.2 Methodology
    3. 1.3 Data
    4. 1.4 Results
    5. 1.5 Concluding Remarks
    6. References
  10. 2. Taking Collateral into Account
    1. 2.1 Introduction
    2. 2.2 Notations and Problem
    3. 2.3 Black–Scholes Partial Differential Equation in the Presence of Collateral
    4. 2.4 Collateral Discount Curve Bootstrapping
    5. 2.5 Pricing and Bootstrapping of the IR Vanilla Swap Term Structure
    6. 2.6 European Swaption Pricing Framework
    7. 2.7 Collateral Effect and Term-Structure Models
    8. 2.8 Conclusion
    9. References
  11. 3. Scenario Analysis in Charge of Model Selection
    1. 3.1 Introduction to Model Risk
    2. 3.2 Classical Calibration Procedure
    3. 3.3 Processes, Dynamics and Model Definition
    4. 3.4 Importance of Risk Premia
    5. 3.5 Equity Volatility Modeling
    6. 3.6 Foreign Exchange Volatility Modeling
    7. 3.7 Conclusions
    8. Note
    9. References
  12. 4. An “Economical” Pricing Model for Hybrid Products
    1. 4.1 Introduction
    2. 4.2 Pricing Convertible Bonds
    3. 4.3 Two-Factor Numerical Procedure
    4. 4.4 Default Risk
    5. 4.5 Pricing Convertible Bonds Subject to Interest Rate Risk and Default Risk
    6. 4.6 Conclusion
    7. Note
    8. References
  13. 5. Credit Valuation Adjustments– Mathematical Foundations, Practical Implementation and Wrong Way Risks
    1. 5.1 Introduction
    2. 5.2 Mathematical Foundations of CVA
    3. 5.3 Practical Implementation: Issues and (Wrong Way) Risks
    4. 5.4 Model Risks in CVA Calculation
    5. 5.5 Summary and Prospects
    6. Notes
    7. References
  14. 6. Counterparty Credit Risk and Credit Valuation Adjustments (CVAs) for Interest Rate Derivatives–Current Challenges for CVA Desks
    1. 6.1 Introduction
    2. 6.2 Traditional Counterparty Risk Management Approaches
    3. 6.3 Modeling Credit Exposure and Pricing CCR
    4. 6.4 New Challenges and Reactions
    5. 6.5 Practical Problems
    6. 6.6 Conclusions and Lessons Learned
    7. References
  15. 7. Designing a Counterparty Risk Management Infrastructure for Derivatives
    1. 7.1 Need for an Integrated Counterparty Risk Management
    2. 7.2 Building Blocks for an Adequate Infrastructure
    3. 7.3 General Computing Approach
    4. 7.4 Trade Assessment
    5. Notes
    6. References
  16. 8. A Jump–Diffusion Nominal Short Rate Model
    1. 8.1 Introduction
    2. 8.2 The Economy
    3. 8.3 Equilibrium Interest Rates and Monetary Policy
    4. 8.4 A Nominal Interest Rate Model
    5. 8.5 Conclusion
    6. Appendix: Proof of Proposition 2
    7. Acknowledgments
    8. References
  17. 9. The Widening of the Basis: New Market Formulas for Swaps, Caps and Swaptions
    1. 9.1 Introduction
    2. 9.2 Assumptions on the Discount Curve
    3. 9.3 Fra Rates: Definition and Pricing
    4. 9.4 IRS Valuation
    5. 9.5 Pricing of Caplets and Swaptions
    6. 9.6 Conclusions
    7. References
  18. 10. The Financial Crisis and the Credit Derivatives Pricing Models
    1. 10.1 Introduction
    2. 10.2 Brief Description of Credit Derivatives
    3. 10.3 CDO Pricing Models and the Financial Crisis
    4. 10.4 Conclusion: Risk Premia and Asset Pricing Models
    5. References
  19. 11. Industry Valuation-Driven Earnings Management
    1. 11.1 Introduction
    2. 11.2 Literature Review and Hypotheses Development
    3. 11.3 Data and Variables
    4. 11.4 Empirical Tests and Results
    5. 11.5 Conclusion
    6. References
  20. 12. Valuation of Young Growth Firms and Firms in Emerging Economies
    1. 12.1 Introduction
    2. 12.2 The Basic Problem
    3. 12.3 Data and Numerical Procedure
    4. 12.4 Results
    5. 12.5 Conclusion
    6. References
  21. 13. Towards a Replicating Market Model for the US Oil and Gas Sector
    1. 13.1 Introduction
    2. 13.2 Model
    3. 13.3 Data
    4. 13.4 Preliminary Analysis and Results
    5. 13.5 Main Results
    6. 13.6 Conclusion
    7. References
  22. 14. Measuring Systemic Risk from Country Fundamentals: A Data Mining Approach
    1. 14.1 Introduction
    2. 14.2 Financial Crises and Leading Indicators
    3. 14.3 Financial Crises and Risk Signals
    4. 14.4 Analysis and Results
    5. 14.5 Conclusions
    6. References
  23. 15. Computing Reliable Default Probabilities in Turbulent Times
    1. 15.1 Introduction
    2. 15.2 Brief Review of the KMV-Merton Model
    3. 15.3 Brief Review of the ZPP Model
    4. 15.4 Empirical Analysis
    5. 15.5 Conclusion
    6. References
  24. 16. Discount Rates, Default Risk and Asset Pricing in a Regime Change Model
    1. 16.1 Introduction
    2. 16.2 Proxy for Discount Rates from a Regime Change Model
    3. 16.3 Leveraging, Risk Premia and Asset Prices using Brownian Motions
    4. 16.4 Discount Rates, Risk Premia and Asset Prices in a Dynamic Model
    5. 16.5 Results of the Numerical Study
    6. 16.6 Conclusions
    7. References
  25. 17. A Review of Market Risk Measures and Computation Techniques
    1. 17.1 Introduction
    2. 17.2 Market Risk, Portfolio Value and Returns
    3. 17.3 Market Risk Factors and Portfolio Value
    4. 17.4 Major Market Risk Measures and Their Computation Methods
    5. 17.5 Backtesting of Market Risk Computation Methods
    6. 17.6 Conclusion
    7. Appendix: Stochastic Processes Used in Finance
    8. References
  26. 18. High-Frequency Performance of Value at Risk and Expected Shortfall: Evidence from ISE30 Index Futures
    1. 18.1 Introduction
    2. 18.2 Literature
    3. 18.3 Market and Data
    4. 18.4 Methodology
    5. 18.5 Empirical Results
    6. 18.6 Conclusion
    7. Notes
    8. References
  27. 19. A Copula Approach to Dependence Structure in Petroleum Markets
    1. 19.1 Introduction
    2. 19.2 Empirical Methodology
    3. 19.3 Data and Results
    4. 19.4 Conclusion
    5. References
  28. 20. Mistakes in the Market Approach to Correlation: A Lesson For Future Stress-Testing
    1. 20.1 Introduction
    2. 20.2 From Flat Correlation towards a Realistic Approach
    3. 20.3 Payoff Stress and the Liquidity Mistake
    4. 20.4 Testing with Historical Scenarios and the Concentration Mistake
    5. 20.5 Lessons for Future Stress-Testing
    6. Notes
    7. References
  29. 21. On Correlations between a Contract and Portfolio and Internal Capital Alliocation
    1. 21.1 Introduction
    2. 21.2 Adding a Deal to a Company Portfolio
    3. 21.3 Example: Correlated Power-Law Distributions
    4. 21.4 Formula for the Quantile Shift
    5. 21.5 Quantile Shift Under Secondary Uncertainty
    6. 21.6 Capital Allocation by Average Shortfall
    7. 21.7 Evolution of Quantiles in Portfolio Aggregation
    8. 21.8 Static and Dynamic Capital Allocation
    9. 21.9 Conclusion
    10. References
  30. 22. A Maximum Entropy Approach to the Measurement of Event Risk
    1. 22.1 Introduction
    2. 22.2 Theory and Methods
    3. 22.3 Empirical Analysis
    4. 22.4 Conclusions
    5. References
  31. 23. Quantifying the Unquantifiable: Risks Not in Value at Risk
    1. 23.1 Introduction and Motivation
    2. 23.2 Regulatory Developments and Requirements
    3. 23.3 Examples of Different Products and Risk Factors
    4. 23.4 Approaches to Quantifying Risks not in VaR
    5. 23.5 Treatment within the Internal Capital Adequacy Process
    6. 23.6 Conclusion and Outlook
    7. Notes
    8. References
  32. 24. Active Portfolio Construction When Risk and Alpha Factors are Misaligned
    1. 24.1 Introduction
    2. 24.2 Framework for Active Portfolio Construction
    3. 24.3 Misalignment of Risk and Alpha Models
    4. 24.4 Portfolio Optimization with Alpha Decomposition
    5. 24.5 Mitigation for Alpha and Risk Factor Misalignment
    6. 24.6 Case Studies
    7. 24.7 Conclusion
    8. References
  33. 25. Market Volatility, Optimal Portfolios and Naive Asset Allocations
    1. 25.1 Introduction
    2. 25.2 Mean and Variance Forecasts
    3. 25.3 Investment Sets
    4. 25.4 Performance Evaluation
    5. 25.5 Results from the Full Sample-Analysis
    6. 25.6 Rolling Performance Evaluation and Market Volatility
    7. 25.7 Conclusions
    8. References
  34. 26. Hedging Strategies with Variable Purchase Options
    1. 26.1 Introduction
    2. 26.2 Description of the Product
    3. 26.3 Pricing and Hedging Bounded VPOs
    4. 26.4 Conclusions
    5. Acknowledgments
    6. References
  35. 27. Asset Selection Using a Factor Model and Data Envelopment Analysis– A Quantile Regression Approach
    1. 27.1 Introduction
    2. 27.3 Data and Methodology
    3. 27.4 Discussion of Results
    4. 27.5 Conclusion
    5. References
  36. 28. Tail Risk Reduction Strategies
    1. 28.1 Introduction
    2. 28.2 Data and Methodology
    3. 28.3 Empirical Results
    4. 28.4 Conclusion
    5. References
  37. 29. Identification and Valuation Implications of Financial Market Spirals
    1. 29.1 Introduction
    2. 29.2 Literature Review
    3. 29.3 Data and Descriptive Statistics
    4. 29.4 Results
    5. 29.5 Conclusion
    6. References
  38. 30. A Rating-Based Approach to Pricing Sovereign Credit Risk
    1. 30.1 Introduction
    2. 30.2 Literature Review and Methodology
    3. 30.3 Dataset
    4. 30.4 Transition Matrices Estimation
    5. 30.5 Asset Pricing
    6. 30.6 Conclusions
    7. Notes
    8. References
  39. 31. Optimal Portfolio Choice, Derivatives and Event Risk
    1. 31.1 Introduction
    2. 31.2 Model
    3. 31.3 Parameter Estimation
    4. 31.4 Optimal Portfolios
    5. 31.5 Conclusion
    6. References
  40. 32. Valuation and Pricing Concepts in Accounting and Banking Regulation
    1. 32.1 Introduction
    2. 32.2 Accounting
    3. 32.3 Banking Regulation
    4. 32.4 Critical Assessment
    5. 32.5 Conclusion
    6. References
  41. 33. Regulation, Regulatory Uncertainty and the Stock Market: The Case of Short Sale Bans
    1. 33.1 Introduction
    2. 33.2 Classical Models: Theoretical Models of Constraining Short Sales
    3. 33.3 Empirical Evidence Prior to the 2008 Financial Crisis
    4. 33.4 Empirical Evidence from and Since the Financial Crisis of 2008
    5. 33.5 Future Challenges
    6. References
  42. 34. Quantitative Easing, Financial Risk and Portfolio Diversification
    1. 34.1 Introduction
    2. 34.2 Financial Markets and Macro-Finance Indicators Before and After 2006
    3. 34.3 Risk Aversion, Risk Premia and the Discounting Process
    4. 34.4 Concluding Remarks
    5. References
  43. 35. Revisiting Interest Rate Pricing Models from an Indian Perspective: Lessons and Challenges
    1. 35.1 Introduction
    2. 35.2 Success and Lessons
    3. 35.3 Challenges
    4. 35.4 Conclusion
    5. References
  44. 36. Investment Opportunities in Australia’s Healthcare Stock Markets After the Recent Global Financial Crisis
    1. 36.1 Introduction
    2. 36.2 Patterned Vecm Modeling and Causality Measurement
    3. 36.3 Data and Empirical Vecm Findings
    4. 36.4 Conclusion
    5. References
  45. 37. Predicting ASX Health Care Stock Index Movements After the Recent Financial Crisis Using Patterned Neural Networks
    1. 37.1 Introduction
    2. 37.2 Construction of a Polynomial Neural Networks Using a Patterned VAR
    3. 37.3 Data and Empirical Sparse-Patterned VAR Findings
    4. 37.4 Conclusion
    5. References
  46. Index