Default swaps and hedging credit baskets

We investigate the pricing of basket credit derivatives and their hedging with single name credit default swaps (CDS) based on a model for the joint dynamics of the fair CDS spreads. In the situation of the market flow of information being a pure jump filtration, we present an extremely efficient approach to pricing and study explicit hedging strategies. --credit default swap,credit basket,hedging

Latin hypercube sampling with dependence and applications in finance

In Monte Carlo simulation, Latin hypercube sampling (LHS) [McKay et al. (1979)] is a well-known variance reduction technique for vectors of independent random variables. The method presented here, Latin hypercube sampling with dependence (LHSD), extends LHS to vectors of dependent random variables. The resulting estimator is shown to be consistent and asymptotically unbiased. For the bivariate case and under some conditions on the joint distribution, a central limit theorem together with a closed formula for the limit variance are derived. It is shown that for a class of estimators satisfying some monotonicity condition, the LHSD limit variance is never greater than the corresponding Monte Carlo limit variance. In some valuation examples of financial payoffs, when compared to standard Monte Carlo simulation, a variance reduction of factors up to 200 is achieved. LHSD is suited for problems with rare events and for high-dimensional problems, and it may be combined with Quasi-Monte Carlo methods. --Monte Carlo simulation,variance reduction,Latin hypercube sampling,stratified sampling

Interest rate convexity and the volatility smile

When pricing the convexity effect in irregular interest rate derivatives such as, e.g., Libor-in-arrears or CMS, one often ignores the volatility smile, which is quite pronounced in the interest rate options market. This note solves the problem of convexity by replicating the irregular interest flow or option with liquidly traded options with different strikes thereby taking into account the volatility smile. This idea is known among practitioners for pricing CMS caps. We approach the problem on a more general scale and apply the result to various examples. --interest rate options,volatility smile,convexity,,option replication

Notes on convexity and quanto adjustments for interest rates and related options

We collect simple and pragmatic exact formulae for the convexity adjustment of irregular interest rate cash flows as Libor-in-arrears or payments of a swap rate (CMS rate) at an irregular date. The results are compared with the results of an approximative approach available in the popular literature. For options on Libor-in-arrears or CMS rates like caps or binaries we derive an additional new convexity adjustment for the volatility to be used in a standard Black & Scholes model. We study the quality of the adjustments comparing the results of the approximative Black & Scholes formula with the results of an exact valuation formula. Further we investigate options to exchange interest rates which are possibly set at different dates or admit different tenors. We collect general quanto adjustments formulae for variable interest rates to be paid in foreign currency and derive valuation formulae for standard options on interest rates paid in foreign currency. --interest rate options,convexity,quanto adjustment,change of numeraire

Cross currency swap valuation

Cross currency swaps are powerful instruments to transfer assets or liabilities from one currency into another. The market charges for this a liquidity premium, the cross currency basis spread, which should be taken into account by the valuation methodology. We describe and compare two valuation methods for cross currency swaps which are based upon using two different discounting curves. The first method is very popular in practice but inconsistent with single currency swap valuation methods. The second method is consistent for all swap valuations but leads to mark-to-market values for single currency off market swaps, which can be quite different to standard valuation results. --interest rate swap,cross currency swap,basis spread

Credit gap risk in a first passage time model with jumps

The payoff of many credit derivatives depends on the level of credit spreads. In particular, credit derivatives with a leverage component are subject to gap risk, a risk associated with the occurrence of jumps in the underlying credit default swaps. In the framework of first passage time models, we consider a model that addresses these issues. The principal idea is to model a credit quality process as an Itô integral with respect to a Brownian motion with a stochastic volatility. Using a representation of the credit quality process as a time-changed Brownian motion, one can derive formulas for conditional default probabilities and credit spreads. An example for a volatility process is the square root of a Lévy-driven Ornstein-Uhlenbeck process. The model can be implemented efficiently using a technique called Panjer recursion. Calibration to a wide range of dynamics is supported. We illustrate the effectiveness of the model by valuing a leveraged credit-linked note. --gap risk,credit spreads,credit dynamics,first passage time models,stochastic volatility,general Ornstein-Uhlenbeck processes

Credit dynamics in a first passage time model with jumps

The payoff of many credit derivatives depends on the level of credit spreads. In particular, the payoff of credit derivatives with a leverage component is sensitive to jumps in the underlying credit spreads. In the framework of first passage time models we extend the model introduced in [Overbeck and Schmidt, 2005] to address these issues. In the extended a model, a credit quality process is driven by an Itô integral with respect to a Brownian motion with stochastic volatility. Using a representation of the credit quality process as a time-changed Brownian motion, we derive formulas for conditional default probabilities and credit spreads. An example for a volatility process is the square root of a Lévy-driven Ornstein-Uhlenbeck process. We show that jumps in the volatility translate into jumps in credit spreads. We examine the dynamics of the OS-model and the extended model and provide examples. --gap risk,credit spreads,credit dynamics,first passage time models,Lévy processes,general Ornstein-Uhlenbeck processes

The accessory bacteriochlorophyll

The primary electron transfer in reaction centers of Rhodobacter sphaeroides is studied by subpicosecond absorption spectroscopy with polarized light in the spectral range of 920-1040 nm. Here the bacteriochlorophyll anion radical has an absorption band while the other pigments of the reaction center have vanishing ground-state absorption. The transient absorption data exhibit a pronounced 0.9-ps kinetic component which shows a strong dichroism. Evaluation of the data yields an angle between the transition moments of the special pair and the species related with the 0.9-ps kinetic component of 26 +/- 8 degrees. This angle compares favorably with the value of 29 degrees expected for the reduced accessory bacteriochlorophyll. Extensive transient absorbance data are fully consistent with a stepwise electron transfer via the accessory bacteriochlorophyll

A graph arising in the Geometry of Numbers

The parametric geometry of numbers has allowed to visualize the simultaneous approximation properties of a collection of real numbers through the combined graph of the related successive minima functions. Several inequalities among classical exponents of simultaneous approximation can be guessed by a study of these graphs; in particular the so called regular graph is of major importance as it provides an extremal case for some of these inequalities. The aim of this paper is to define and construct an analogue of the regular graph in the case of weighted simultaneous approximation.Comment: 8 pages, 2 figure

Diophantine problems in variables restricted to the values 0 and 1

AbstractLet Fx1,…,xs be a form of degree d with integer coefficients. How large must s be to ensure that the congruence F(x1,…,xs) ≡ 0 (mod m) has a nontrivial solution in integers 0 or 1? More generally, if F has coefficients in a finite additive group G, how large must s be in order that the equation F(x1,…,xs) = 0 has a solution of this type? We deal with these questions as well as related problems in the group of integers modulo 1 and in the group of reals