Archive for the ‘Derivatives’ Category

Are our models too complex?

June 17, 2012

Gillian Tett is a well-respected writer for the Financial Times and frequently picks up the topic of complexity in financial markets.

In a recent article (see here) she makes a case that the era of number crunching is over, and that the world of investments is back again firmly in the domain of human relationships and evaluations.

Once upon a time we would measure credit risk with a numbers like survival probability stripped from CDS market prices. Once upon a time we were all happy to value a transaction with models that almost no-one other than the quants understood.

Her view is that these times are gone.

Smile, it’s Volga!

April 9, 2012

Armed with the Hardy Decomposition for option prices, it now becomes much easier to understand why the smile exists.

To be clear, options trader might use the smile to manage supply & demand, but here we discuss the mathematical basis for smile – which is important if you want to understand how to generate smile in a monte-carlo model.

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Calculating option prices in your head

April 5, 2012

We all know that option prices are calculated with the Black-Scholes formula, using a volatility, time-to-maturity, strike and forward. Typically you just chuck them all into your computer and let it spit out the number.

Trouble with this is how do you get an intuition for prices, especially when you are looking at options trades like conditional steepeners or calendar spreads?

Recently I set myself the problem of getting some simple way to cross-check the numbers coming out of my PC, and to get some intuition for the way an option’s value decays to its intrinsic value as the forward moves (which is what you definitely need for options trading).

In this post I show you a simple approximation I have found which does a pretty stellar job of accurately telling you the price of an option at any strike, and which you can calculate in your head!

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