Valuation of Credit Contingent Options with Applications to Quanto CDS

--Anlong Li

This paper studies the valuation of credit contingent asset or options by modeling the correlation between asset price and credit default. It provides three ways of modeling such correlation: (1) asset value follows a diffusion process with a one-time jump (such as currency devaluation) at the time of credit default; (2) Default intensity and asset price are driven by correlated Brownian motions in addition to the jump; (3) Default time and future asset price are correlated through a copula. When both asset price and credit default are independent of interest rates, such contract can be valued on a two-dimensional lattice (or finite-difference grid) in the second approach. The paper shows that for a large class of one-factor default rate models, the computation can be reduced to one-dimension, a property often reserved for the affine class of models. It also obtains analytical solutions if default hazard rate, asset price return, and the copula are all Gaussian. Experience shows that valuation is much more sensitive to the first and third type of correlations. The paper applies the model to the valuation of extinguishable FX swaps that terminate upon a credit event and quanto credit default swaps, where premium and protection legs are paid in different currencies.

© 2008 IUP . All Rights Reserved.

Mortgage-Backed Securities and Financial Innovation Experience of Malaysia

--Kok Lee Kuin, L V L N Sarma and Suganthi Ramasamy

Malaysian government had set out its policy of encouraging home-ownership among low and medium income groups since 1970s. As a part of this drive, Cagamas Berhad (the National Mortgage Corporation of Malaysia) was established in 1986. The objective of this corporation is to securitize the mortgage loans and offer these securities in the debt market. Cagamas aims at the realization of: (1) enabling home-ownership financing agencies to gain greater mileage out of the limited resources available; and (2) to increase the breadth of bond market in Malaysia and make it active. Cagamas started issuing asset-backed securities called Residential Mortgage Backed Securities (RMBS) effectively from 2001. It has also commenced issuing other asset-backed securities covering plantation assets, credit cards, students loans, etc. Other financial institutes have also commenced issuing asset-backed securities and they are called in this paper as Private Labelled Asset-Backed Securities (PLABS). The objective of this study is to assess the attractiveness of RMBS of cagamas to the investors relative to the Conventional Corporate Bonds, and PLABS. The paper concludes that RMBS are gaining ground in Malaysia and hold promise to invigorate Bond Market (especially, Derivatives Market) in Malaysia.

© 2008 IUP . All Rights Reserved.

Multi-Currency Local Volatility Model

--Daniel Bloch and Yukio Nakashima

This paper establishes the need for local volatility coupled with domestic and foreign stochastic interest rates to properly manage some exotic hybrid options. It then computes such a local volatility and identifies a bias with respect to the local volatility with deterministic rates. Performing variance-covariance analysis on the logarithm of the underlying price together with the domestic and foreign spot rates, the paper estimates that bias by calculating the variances of the logarithm of the underlying price with and without stochastic rates at fixed points in time and in space. Equating the resulting variances, the authors express the local volatility with stochastic rates in terms of the one with deterministic rates plus a bias obtaining an exact, fast and robust way of calibrating any local volatility with stochastic rates to market prices.

© 2008 IUP . All Rights Reserved.

Impact of Futures Trading Activity on Stock Price Volatility of NSE Nifty Stock Index

--Sathya Swaroop Debasish

This paper attempts an empirical examination of effect of futures trading activity on the jump volatility of the stock market by taking a case of NSE Nifty stock index. Two alternative measures of the intensity of futures trading activity employed are the monthly stock index futures trading volume and the monthly open interest in the NSE Nifty index futures contract. A span period of eight years from June 2000 to May 2007 for monthly data is used. Using the FPE/multivariate Granger causality modeling technique, this study examines whether activities in the futures market and other relevant factors have Granger-caused jump volatility of stock prices. The macroeconomic variable used in the study are volatility of the term structure of interest rates; volatility of the NSE Junior index (proxy index with no futures trading); volatility in the risk premium; volatility of the inflation rate; and volatility of the industrial production index. The study finds that futures trading activity (measured in both trading volume and open interest) is not a force behind the episodes of jump volatility. Moreover, the volatility of other macroeconomic variables, such as inflation and risk premium, are not responsible for the volatility in stock prices of NSE Nifty.

© 2008 IUP . All Rights Reserved.