Exercises of Libor market model of Damiano Brigo given at Imperial College of London.

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Exercises of Libor market model of Damiano Brigo given at Imperial College of London.

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Mathematical Finance Section

Dept. of Mathematics

1 / 143

Content I

1

EXERCISES

Absence of Arbitrage in Black Scholes

Zero coupon bonds and rates

Spot, forward and swap rates

Put Call Parity Violation and Arbitrage

Transformations of Vasicek models

Dynamics for rt

Instantaneous Forward Rates and HJM drift condition in G2++

LIBOR fourth payoff

Swaptions

LIBOR MODEL CALIBRATION

Deterministic intensities / hazard rates

CIR model for default intensity

CVA for Bonds

CVA for Call option

2 / 143

Content II

CVA for Bonds portfolio

Risk Measures

3 / 143

EXERCISES

Scholes I

account and a stock, whose prices are given respectively by

dBt = rBt dt, B0 = 1,

dSt = St dt + St dWt , S0 = 1

the physical measure P.

Consider the limiting case where = 0, ie the stock has no volatility.

Prove that if 6= r then one has arbitrage.

4 / 143

EXERCISES

Scholes II

SOLUTION. To prove arbitrage we need to prove that there exists at

least one arbitrage opportunity, ie a self-financing trading strategy

(B , S ) such that

B0 B0 + S0 S0 = 0, BT BT + ST ST > 0 a.s.

for some maturity T > 0.

Let us start for the case where > r . We may easily establish an

arbitrage opportunity as follows.

At time 0 we buy S0 = 1 unit of stock and short-sell 1 unit of bank

account: B0 = 1.

This has cost zero as both positions have a value of 1 at time 0:

B0 B0 + S0 S0 = (1) 1 + 1 1 = 0.

(c) 2012-13 D. Brigo (www.damianobrigo.it)

5 / 143

EXERCISES

Scholes III

Integrating the bank account and stock equations

dBt = rBt dt,

dSt = St dt

Since > r , our strategy is just to wait, as S grows with and B with r .

So now our strategy is to hold onto the initial amounts without buying

or selling anything.

Bt = 1, St = 1 for allt,

0 < t < T.

funding or any extraction of money from the accounts.

At maturity we have

(c) 2012-13 D. Brigo (www.damianobrigo.it)

6 / 143

EXERCISES

Scholes IV

BT BT + ST ST = (1) erT + 1 eT > 0

since > r .

If < r we do the opposite: at time zero we buy one unit of Bank

account and go short one unit of stock, and then just wait. The

reasoning is analogous.

This exercise shows an important point: we cannot have two bank

accounts accruing at different rates, or we have immediately arbitrage.

Also, note that in this case the Radon Nykodym derivative dQ/dP

would not be well defined.

(c) 2012-13 D. Brigo (www.damianobrigo.it)

7 / 143

EXERCISES

Assume that the zero coupon bond term structure is given by

P(0, T ) = exp(kT 2 ), 0 < k ()

a) Write an expression for the LIBOR spot rate L(0, T ) as a function of

T.

b) Write an expression for the LIBOR forward rate F (0, T , T + 1) as a

function of T .

c) Study F (0, T , T + 1) as a function of k . Is it increasing, decreasing,

concave, convex, how does it behave at 0 and infinity?

d) Compute the swap rate S(0, 0, 2) = S0,2 (0) for a swap with annual

tenor in both legs, and compute the limits for k going to zero and

infinity of this swap rate.

(c) 2012-13 D. Brigo (www.damianobrigo.it)

8 / 143

EXERCISES

defined as

1

R(t, T ) =

ln P(t, T ).

T t

Find an explicit expression for R(0, T ) when the bond follows (*) above.

f) By making use of point e), find the short rate r0 at time 0.

9 / 143

EXERCISES

SOLUTIONS:

a)

L(0, T ) =

1

1

1

2

2

(1/P(0, T ) 1) = (1/ekT 1) = (ekT 1)

T

T

T

b)

F (0, T , T +1) =

1

2

2

(P(0, T )/P(0, T +1)1) = ekT /ek(T +1) 1

T +1T

= ek(2T +1) 1

c)

(c) 2012-13 D. Brigo (www.damianobrigo.it)

10 / 143

EXERCISES

The map

k 7 (ek(2T +1) 1)

is increasing, convex, at infinity goes to infinity, at 0 goes to 0.

d)

S(0, 0, 2) =

1 P(0, 2)

1 e4k

e4k 1

= k

=

1 P(0, 1) + 1 P(0, 2)

e + e4k

e3k + 1

e)

R(0, T ) = kT

f)

r0 = lim R(0, T ) = lim kT = 0

T 0

T 0

11 / 143

EXERCISES

Consider the following curve of zero coupon bonds for the maturities

T0 = 1y, T1 = 2y , . . . , T9 = 10y:

P(0, T0 ) = 0.961538462 P(0, T1 ) = 0.924556213

P(0, T2 ) = 0.888996359 P(0, T3 ) = 0.854804191

P(0, T4 ) = 0.821927107

a) Compute the forward swap rates S1,4 (0) and S2,4 (0).

b) Compute the forward libor rates F1 (0), F2 (0), ... and verify that the

swap rate S2,4 (0) is a weighted average of the forward LIBOR rates (in

particular, compute the weights).

12 / 143

EXERCISES

SOLUTIONS:

a) We have an annual tenor structure where Ti Ti1 = 1 year. This is

important in defining all rates.

S1,4 (0) =

P(0, T1 ) P(0, T4 )

1 P(0, T2 ) + 1 P(0, T3 ) + 1 P(0, T4 )

Similarly we obtain

S2,4 (0) =

P(0, T2 ) P(0, T4 )

1 P(0, T3 ) + 1 P(0, T4 )

b) We know that

S2,4 (0) = w3 (0)F3 (0) + w4 (0)F4 (0),

(c) 2012-13 D. Brigo (www.damianobrigo.it)

13 / 143

EXERCISES

where

w3 (0) = P(0, T3 )/(P(0, T3 ) + P(0, T4 )),

w4 (0) = P(0, T4 )/(P(0, T3 ) + P(0, T4 )).

Also,

F3 (0) =

1

1

P(0, T2 )

1 P(0, T3 )

1 ; F4 (0) =

1 .

P(0, T3 )

1 P(0, T4 )

14 / 143

EXERCISES

Arbitrage I

Consider the Black and Scholes basic economy given by a bank

account and a stock, whose prices are given respectively by

dBt = rBt dt, B0 = 1,

dSt = St dt + St dWt , S0 = 1

the physical measure P.

Consider two options that are at the money forward, namely having

strike

K = S0 erT ,

respectively a call option and a put option with maturity T and payout

(ST K )+ = max(ST K , 0) (Call), (K ST )+ = max(K ST , 0) (Put).

(c) 2012-13 D. Brigo (www.damianobrigo.it)

15 / 143

EXERCISES

Arbitrage II

In this case, put call parity tells us that the initial value of the call

option, at time 0, must be equal to the initial value of the put option,

given that the forward contract value is zero (K is the at-the-money

forward strike that sets the forward price to zero).

Show that if this condition is violated, and for example

CallPrice0 = PutPrice0 + X

for a positive amount X > 0, one has arbitrage.

16 / 143

EXERCISES

Arbitrage III

SOLUTION.

Since the price of the call is larger than the one of the put when they

should actually be the same, we can try by buying a put and

short-selling a call, and buying an at the money forward contract to

balance put minus call at maturity. We also buy some bank account

with the difference between the call and the put at time 0.

We enter into one position in a put option at time 0, and short sell one

call option at time 0, both options with strike K and maturity T . We

also enter into a forward contract at the same maturity with strike K .

This means that we accept to receive ST K at maturity (meaning that

if this quantity is positive we receive it, if it is negative we pay its

absolute value to our counterparty in the trade). We also buy an

amount X of bank account.

(c) 2012-13 D. Brigo (www.damianobrigo.it)

17 / 143

EXERCISES

Arbitrage IV

We pay PutPrice0 to enter into the put option

we receive CallPrice0 = PutPrice0 + X by short-selling the Call

option

We pay X to buy a quantity X of bank account B0 at time 0.

We pay nothing to enter into the forward contract since its initial

cost is S0 KerT = 0.

18 / 143

EXERCISES

Arbitrage V

These four operations have a total cost of

PutPrice0 CallPrice0 + X + 0 = 0

So it costs nothing setting up the strategy.

Following the initial setup, we just wait. This clearly preserves the self

financing condition since we do not inject external funds or extracts

funds from the strategy.

At maturity, we have the following cash flows:

We receive (K ST )+ from the Put option.

We pay (ST K )+ for the Call option we have been short-selling

We receive ST K from the forward contract

We have XerT in the bank account.

(c) 2012-13 D. Brigo (www.damianobrigo.it)

19 / 143

EXERCISES

Arbitrage VI

PutPayoutT CallPayoutT + FwdContractPayoutT + XBT =

(K ST )+ (ST K )+ + ST K + XerT =

= K ST + ST K + XerT = XerT > 0

So we have a self-financing trading strategy whose initial cost is zero

and that produces a positive final cash flow XerT in all scenarios.

Hence this is an arbitrage opportunity and the market is arbitrageable.

20 / 143

EXERCISES

model I

dxt = k ( xt )dt + dWt , x0

where W is a brownian motion under the risk neutral measure.

a) Assume rt = xt + 0.01. Compute a formula for the risk neutral

probability that the short rate is negative at a time T .

b) Assume = 0 and set rt = (xt )3 . Find the stochastic differential

equation for the short rate.

21 / 143

EXERCISES

model II

SOLUTIONS: a) We know that in the Vasicek model the short rate at

time t conditional on time s is normally distributed with mean and

variance given by

E{x(t)|xs } = x(s)ek(ts) + 1 ek(ts)

i

2 h

1 e2k(ts) .

2k

It follows that the short rate rt = xt + 0.01 at time T conditional on time

0 is

VAR{x(t)|xs } =

rT Normal(0.01 + mT , VT2 )

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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EXERCISES

model III

i

2 h

mT = x(0)ekT + 1 ekT , VT2 =

1 e2kT

2k

The probability that a normal distribution is negative is

Q{rT < 0} = Q{Normal(0.01 + mT , VT2 ) < 0} =

= Q{0.01 + mT + VT Normal(0, 1) < 0} =

= Q{Normal(0, 1) < (0.01 + mT )/VT } = ((0.01 + mT )/VT )

b).

We use Itos formula.

1

d(xt )3 = 3xt2 dxt + 3 2xt dxt dxt =

2

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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EXERCISES

model IV

= 3xt2 k( xt )dt + 3xt2 dWt + 3xt 2 dt

d(xt )3 = 3[xt2 k( xt ) + xt 2 ]dt + 3xt2 dWt

1/3

2/3

drt = 3[rt

. We have

1/3 2

k krt + rt

2/3

]dt + 3rt

dWt

By setting = 0 we obtain

1/3 2

drt = 3[krt + rt

2/3

]dt + 3rt

dWt

24 / 143

EXERCISES

Dynamics for rt

Consider the following model for the risk neutral dynamics of the short

rate:

drt = k dt + dWt , r0

where W is a Brownian motion under the risk neutral measure Q and

where k, and r0 are positive real numbers.

a) Compute the zero coupon bond price P(0, T ).

b) Compute the term structure of Interest Rates T 7 L(0, T )

associated with the model.

c) Is the dynamics realistic? List the advantages and the drawbacks of

this model.

25 / 143

EXERCISES

Dynamics for rt

SOLUTION.

a) Let us begin by solving the equation for the short rate:

drs = k ds + dWs .

Integrating both sides between 0 and t we obtain

rt r0 = k (t 0) + (Wt W0 )

so that

rt = r0 + kt + Wt ()

To compute the bond price we need to compute

"

!#

Z

T

P(0, T ) = E exp

rt dt

0

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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EXERCISES

Dynamics for rt

Let us begin with

Z

rt dt =?

0

integration by parts:

Z

0

T Z

rt dt = t rt

t drt

Z

Z

rt dt = T rT

or

Z

Z

rt dt = T rT

t(kdt + dWt )

0

Z

t k dt

0

Master Exercises Prof. Brigo

t dWt

0

Imperial College London

27 / 143

EXERCISES

Dynamics for rt

Now we also substitute rT from equation () written at t = T :

T

rt dt = T (r0 + kT + WT ) kT /2

0

t dWt

0

We have

T

rt dt = Tr0 + kT 2 + T WT kT 2 /2

or

Z

t dWt

0

dWt kT /2

rt dt = Tr0 + kT + T

0

Z

X :=

t dWt

0

RT

0

dWt . We obtain

rt dt = Tr0 kT 2 /2

0

(c) 2012-13 D. Brigo (www.damianobrigo.it)

(T t) dWt

0

28 / 143

EXERCISES

Dynamics for rt

This last equation is the sum of a deterministic constant plus a Ito

integral. The Ito Integral has a deterministic integrand. Hence it is the

limit of a sum of independent gaussian random variables (increments

dW ) each multiplied by a constant, and so it is itself gaussian. By

using the Ito isometry, we may determine its mean and variance. We

know that

Z

T

(T t) dWt ] = 0

E[

0

and

Z

Z

(T t) dWt ] =

VAR[

0

2 (T t)2 dt = 2 T 3 / 3

Z

P(0, T ) = E[exp(

rt dt)] = E[exp(X )]

0

29 / 143

EXERCISES

Dynamics for rt

where X is a normal of mean = Tr0 kT 2 /2 and Variance

V 2 = 2 T 3 19/3. Hence, recalling the moment generating function of a

Normal random variable,

P(0, T ) = E[exp(X )] = exp( + V 2 /2)

we have

P(0, T ) = exp(Tr0 kT 2 /2 + 2 T 3 /6)

b). We need to compute

1

1

1

L(0, T ) =

1 =

exp(Tr0 + kT 2 /2 2 T 3 /6) 1

T P(0, T )

T

c). The dynamics is not very realistic, as we explain in the

disadvantages below.

(c) 2012-13 D. Brigo (www.damianobrigo.it)

30 / 143

EXERCISES

Dynamics for rt

Advantages. The model is very tractable. One can make several

calculations, as we did before, and obtain bonds and interest rate

options in closed form. Since it is Gaussian, it is also very easy to

simulate.

Disadvantages. There are several disadvantages.

rT is a gaussian random variable at all future times T . Hence it will

have a positive probability of taking negative values. Since

negative interest rates are not desirable, this is a drawback.

Depending on the value of the parameters, this probability can be

large.

We may compute it easily using formula ():

(c) 2012-13 D. Brigo (www.damianobrigo.it)

31 / 143

EXERCISES

Dynamics for rt

The Gaussian distribution has thin tails. Historical estimation

suggests that financial variables usually have fatter tails than in

the Gaussian case.

The future mean of the model, again from (), is

E[rt ] = r0 + kt

and keeps growing linearly in time with rate k. So our model has a

linearly increasing average interest rate that, after a while, will

reach unrealistically high expected values. The larger k, the faster

this unrealistic growth.

32 / 143

EXERCISES

Dynamics for rt

The future variance of the model, again from (), is

VAR[rt ] = 2 t.

The variance keeps growing and never reaches a steady state.

The model, in particular, is not mean reverting, as both mean and

variance tend to infinity as time grows.

It is an endogenous model, in that the initial zero curve

T 7 L(0, T ) is an output of the model rather than an input, and

the formula we derived for T 7 L(0, T ) suggests that the model

will only be able to reproduce very stylized initial term structures.

33 / 143

EXERCISES

In the G2++ Model, the instantaneous-short-rate process is given by

r (t) = x(t) + y (t) + (t),

r (0) = r0 ,

dx(t) = ax(t)dt + dW1 (t), x(0) = 0,

dy (t) = by (t)dt + dW2 (t), y (0) = 0,

where (W1 , W2 ) is a two-dimensional Brownian motion with

instantaneous correlation as from

dW1 (t)dW2 (t) = dt,

34 / 143

EXERCISES

where r0 , a, b, , are positive constants, and 1 1. The

function is deterministic and well defined in the time interval [0, T ],

with T a given time horizon, typically 10, 30 or 50 (years).

We know that the bond price formula for G2++ model is given by

( Z

T

1 ea(T t)

P(t, T ) = exp

(u)du

x(t)

a

t

)

1 eb(T t)

1

y(t) + V (t, T ) .

b

2

35 / 143

EXERCISES

where

2

2 a(T t)

1 2a(T t)

3

V (t, T ) = 2 T t + e

a

2a

2a

a

1 2b(T t)

3

2

2 b(T t)

+ 2 T t + e

b

2b

2b

b

"

ea(T t) 1 eb(T t) 1

+2

T t +

+

ab

a

b

#

e(a+b)(T t) 1

.

a+b

36 / 143

EXERCISES

model.

b) Write the SDEs for the dynamics of f (t, T ) and, in particular, the

expression for the instantaneous volatility (t, T ) of f (t, T ).

c) Double check that the SDEs you found in point b) satisfy the HJM

drift condition for no arbitrage.

37 / 143

EXERCISES

SOLUTION.

a) With reference to previous calculations done in the course, where

we had found that

( Z

T

1 ea(T t)

(u)du

P(t, T ) = exp

x(t)

a

t

)

1

1 eb(T t)

y (t) + V (t, T ) ,

b

2

with

38 / 143

EXERCISES

2

2 a(T t)

1 2a(T t)

3

V (t, T ) = 2 T t + e

a

2a

2a

a

1 2b(T t)

3

2

2

e

+ 2 T t + eb(T t)

b

2b

2b

b

"

ea(T t) 1 eb(T t) 1

+2

T t +

+

ab

a

b

#

e(a+b)(T t) 1

,

a+b

39 / 143

EXERCISES

we now write

ln P(t, T )

(ZT

T

1 ea(T t)

1 eb(T t)

=

(u)du +

x(t) +

y (t)

T

a

b

t

1

V (t, T )

2

1 V

,

= (T ) + ea(T t) x(t) + eb(T t) y(t)

2 T

f (t, T ) =

40 / 143

EXERCISES

where

2

V

2

= 2 1 2ea(T t) + e2a(T t) + 2 1 2eb(T t) + e2b(T t)

T

a

b

a(T t)

b(T t)

+ 2

1e

e

+ e(a+b)(T t)

ab

2 2

2

2

= 2 1 ea(T t) + 2 1 eb(T t)

a

b

a(T t)

1 eb(T t) .

1e

+ 2

ab

So we have

2

2

a(T t)

1

e

2a2

2

2

2 1 eb(T t)

1 ea(T t) 1 eb(T t) .

ab

2b

()

41 / 143

EXERCISES

formula to eat x(t),

Since dx(t) = ax(t)dt + dW1 (t), if we apply Itos

we have

d(eat x(t)) = aeat x(t)dt + eat dx(t)

= aeat x(t)dt aeat x(t)dt + eat dW1 (t) = eat dW1 (t).

Integrate from time 0 to t for both side, we get

Z t

eat x(t) =

eas dW1 (s),

0

t

Z

x(t) =

Z

y(t) =

0

(c) 2012-13 D. Brigo (www.damianobrigo.it)

42 / 143

EXERCISES

Substitute x(t) and y (t) into the formula () we have just derived for

f (t, T ), and we have

2

2

2

2

a(T t)

b(T t)

1

e

1

2a2

2b2

1 ea(T t) 1 eb(T t)

ab

Z t

Z t

a(ts)

+

e

dW1 (s) +

eb(ts) dW2 (s).

f (t, T ) = (T )

43 / 143

EXERCISES

formula:

b) Apply Itos

df (t, T ) =

f

f

f

1 2f

1 2f

dt +

dXt +

dYt +

dX

dX

+

dYt dYt

t

t

t

X

Y

2 Xt2

2 Yt2

+

2f

dXt dYt .

X Y

2

f

2 a(T t)

1 ea(T t) + eb(T t) 1 eb(T t)

=

e

t

a

b

a(T t)

b(T t)

1e

+ eb(T t) 1 ea(T t) )

+ e

b

b

a(T t)

b(T t)

+ ae

x(t) + be

y (t),

f

= ea(T t) ,

X

(c) 2012-13 D. Brigo (www.damianobrigo.it)

f

= eb(T t) ,

Y

44 / 143

EXERCISES

and

2f

2f

2f

=

=

= 0.

X Y

Xt2

Yt2

Thus,

f

dt aea(T t) xt dt + ea(T t) dW1,t

t

beb(T t) yt dt + eb(T t) dW2,t

2

2

a(T t)

=

e

1 ea(T t) + eb(T t) 1 eb(T t)

a

b

a(T t)

1 eb(T t)

+ e

b

i

+ eb(T t) 1 ea(T t) dt

b

+ ea(T t) dW1,t + eb(T t) dW2,t .

df (t, T ) =

45 / 143

EXERCISES

We denote as f (t, T ) the drift of this model, and

f (t, T ) as the

volatility of the model, and the dynamics of f (t, T ) can be written as

dW1,t

df = f (t, T )dt +

f (t, T )

,

dW2,t

where the volatility can be written explicitly as a row vector

This volatility vector however does not represent the whole covariance

of the system, since correlation is also present in the brownian

motions, as we have

dhW1 , W2 it = dW1,t dW2,t = dt.

(c) 2012-13 D. Brigo (www.damianobrigo.it)

46 / 143

EXERCISES

To have a vector volatility representing the entire instantaneous

covariance structure of the system of interest rates, we now

incorporate the correlation into the volatility vector. This is achieved

through a Cholesky decomposition technique.

In dimension 2, this is as follows. We construct

another two

dimensional Brownian Motion B1,t , B2,t (not to be confused with the

bank account B) such that B1,t and B2,t are independent. Assume

W1,t = B1,t

W2,t = B1,t +

p

1 2 B2,t .

this way are standard Brownian motions in dimension one, and also

that their quadratic covariation is . Hence we have constructed a

(c) 2012-13 D. Brigo (www.damianobrigo.it)

47 / 143

EXERCISES

representation of our two correlated Brownian motion in terms of two

independent ones.

Then, we have

1

0

dB

1,t

a(T t)

b(T t)

p

df = f (t, T )dt + e

, e

.

dB2,t

1 2

obtain the

vector volatility of the model with respect to B1,t , B2,t :

1

0

p

f (t, T ) = e

, e

1 2

p

= ea(T t) + eb(T t) , 1 2 eb(T t) .

a(T t)

b(T t)

the system.

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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EXERCISES

c) To check that this model satisfies the HJM drift condition for no

arbitrage, we need to check that

!

Z

T

f (t, T ) = f (t, T )

f (t, s)0 ds

where we have a matrix product in the right hand side and where the

notation 0 denotes transposition. Also, the time integral of vectors is

defined componentwise, namely by integrating each component

function.

49 / 143

EXERCISES

We have easily

Z

f (t, T )

!0

f (t, s)ds

t

= f (t, T )

b(T t)

b e

eb(T t) 1

a ea(Tt) 1

12

b

!

1

2

2 a(T t)

e

1 ea(T t) + eb(T t) 1 eb(T t)

a

b

a(T t)

b(T t)

+ eb(T t) 1 ea(T t)

+ e

1e

b

b

= f (t, T ).

50 / 143

EXERCISES

Consider a contract paying in T4 =four years the fourth power of the

LIBOR rate that resets in T3 =three years plus a positive strike K > 0,

if the total of this sum is positive, and zero otherwise.

a) Compute the pricing formula of this product, namely

B(0)

B(0)

4

+

4

+

(L(T3 , T4 ) + K ) = E

(F4 (T3 ) + K )

V =E

B(T4 )

B(T4 )

in a LIBOR market model setting

dF4 (t) = 4 F4 (t)dZ4 , Q 4

as a function of the constant volatility 4 , of the initial forward F4 (0), of

the bond P(0, T4 ) and of the strike K .

b) Is this product sensitive to volatility of interest rates? Motivate

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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EXERCISES

sensitivity of the product price to volatility, namely

V=

V

4

52 / 143

EXERCISES

SOLUTION:

a)

We change the numeraire from B to the T4 -forward measure

numeraire P(, T4 ):

B(0)

P(0, T4 )

4

+

4

+

B

4

(F4 (T3 ) + K ) = E

(F4 (T3 ) + K )

E

B(T4 )

P(T4 , T4 )

= P(0, T4 )E 4 [(F4 (T3 )4 + K )+ ].

Now, since the rate F is positive and K is positive too, we have that the

sum F4 (T3 )4 + K is positive in all scenarios,

F4 (T3 )4 + K 0.

It follows that the positive part in the option term is not necessary,

namely

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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EXERCISES

(F4 (T3 )4 + K )+ = max(F4 (T3 )4 + K , 0) = F4 (T3 )4 + K

in all scenarios. Hence our pricing formula reduces to

V = P(0, T4 )E 4 [(F4 (T3 )4 + K )+ ] = P(0, T4 )E 4 [F4 (T3 )4 + K ] =

= P(0, T4 )(E 4 [F4 (T3 )4 ] + K ).

All we have to compute then is

E 4 [(F4 (T3 )4 ].

Since we know that the dynamics of F4 under numeraire P(., T4 ) is

dF4 = 4 F4 dZ ,

by Itos formula

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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EXERCISES

1

d(F4 )4 = 4(F4 )3 dF4 + 4 3 (F4 )2 dF4 dF4

2

d(F4 )4 = 4(F4 )3 4 F4 dZ + 6F42 42 F42 dZdZ

d(F4 )4 = 4(F4 )4 4 dZ + 6F44 42 dt

Set Yt = (F4 (t))4 . From the last equation we have

dY = (642 )Ydt + (44 )YdZ .

This is a Black Scholes geometric brownian motion of type

dY = aYdt + bYdZ

(a = 642 , b = (44 )) whose expected value is

E[Y (T )] = Y0 eaT

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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EXERCISES

P(0, T4 )(E 4 [F4 (T3 )4 ] + K ) = P(0, T4 )(E[Y (T3 )] + K ) =

= P(0, T4 )(Y0 eaT3 + K )

2

56 / 143

EXERCISES

b) We see clearly that the price

V = P(0, T4 )(F4 (0)4 e

42

T3

+ K)

c)

h

i

4 e642 T3 + K )

P(0,

T

)(F

(0)

4

4

V

=

V=

4

4

h

i

2

F4 (0)4 e64 T3

2

= P(0, T4 )

= P(0, T4 )F4 (0)4 e64 T3 12 4 T3 .

4

57 / 143

EXERCISES

Swaptions

Consider the following curve of zero coupon bonds for the maturities

T0 = 1y, T1 = 2y , . . . , T9 = 10y:

P(0, T0 ) = 0.961538462 P(0, T1 ) = 0.924556213

P(0, T2 ) = 0.888996359 P(0, T3 ) = 0.854804191

P(0, T4 ) = 0.821927107

a) Compute the forward swap rates S1,4 (0) and S2,4 (0).

b) Compute the forward libor rates F1 (0), F2 (0), ... and verify that the

swap rate S2,4 (0) is a weighted average of the forward LIBOR rates (in

particular, compute the weights).

c) Consider an option to enter a payer swap first resetting at T2 = 3y

and lasting up to T4 = 5y with a fixed rate equal to K = 5%. Let the

volatility of the underlying swap rate be 20%. Compute the price of the

related option.

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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EXERCISES

Swaptions

d) Same as c) but the underlying swap is a receiver swap and the fixed

rate is K = 3%.

59 / 143

EXERCISES

Swaptions

Solutions

The first two points have been solved in an earlier exercise above.

c) The annuity numeraire is C2,4 (0) = 1 P(0, T3 ) + 1 P(0, T4 ). We also

have

d1,2 =

ln(0.04/0.05) 21 (0.2)2 3

ln(S2,4 (0)/K ) 21 2 T2

=

.

T2

0.2 3

C2,4 (0)[S2,4 (0)(d1 ) K (d2 )]

and inserting the given numbers we obtain the result.

d) Similar to c). One obtains (for example by put call parity)

C2,4 (0)[K (d1 ) S2,4 (0)(d2 )]

(c) 2012-13 D. Brigo (www.damianobrigo.it)

60 / 143

EXERCISES

Consider the following tenor structure:

T0 = 1y, T1 = 2y , T2 = 3y, . . . , T5 = 6y .

Consider the associated forward LIBOR rates Fi (t) = F (t; Ti1 , Ti ),

i = 1, . . . , 6, whose instantaneous volatility we denote by i (t).

Consider the Caplet volatilities vTCaplet

=: vi1 for the caplet resetting at

i1

Ti1 with maturity Ti .

a) Given the following caplet volatilities

v0 = 0.1; v1 = 0.12; v2 = 0.15;

v3 = 0.14; v4 = 0.13; v5 = 0.12

compute the LIBOR model vols i (t) consistent with these data in case

we assume i (t) = ik for t [Tk1 , Tk ] :

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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EXERCISES

Inst. Vols

Fwd : F1 (t)

F2 (t)

..

.

FM (t)

t (0, T0 ]

1

2

(T0 , T1 ]

Dead

1

(T1 , T2 ]

Dead

Dead

...

...

...

(TM2 , TM1 ]

Dead

Dead

...

M

...

M1

...

M2

...

...

...

1

point on the output you obtain.

c) Given the same input as in part a), compute the LIBOR model

volatilities under the assumption i (t) = i .

Inst. Vols

Fwd : F1 (t)

F2 (t)

..

.

FM (t)

t (0, T0 ]

1

2

(T0 , T1 ]

Dead

2

(T1 , T2 ]

Dead

Dead

...

...

...

(TM2 , TM1 ]

Dead

Dead

...

M

...

M

...

M

...

...

...

M

62 / 143

EXERCISES

d) Again, repeat the same calculation as in c) but with v5 = 0.08. Do

you find the same problems as in point b) ?

e) Given the following separable volatilities, i (t) = i ik for

t [Tk1 , Tk ),

Inst. Vols

Fwd : F1 (t)

F2 (t)

..

.

FM (t)

t (0, T0 ]

1 1

2 2

(T0 , T1 ]

Dead

2 1

(T1 , T2 ]

Dead

Dead

...

...

...

(TM2 , TM1 ]

Dead

Dead

...

M M

...

M M1

...

M M2

...

...

...

M 1

1 = 1, 2 = 1.1, 3 = 1.2, 4 = 0.9, 5 = 0.8, 6 = 1.1

1 = 0.1, 2 = 0.12, 3 = 0.12, 4 = 0.09, 5 = 0.08, 6 = 0.11

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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EXERCISES

f) With the same volatilities as in e), plot also the evolution of the term

structure of caplet volatilities in time up to five years in the future.

g) Find the exponential Full rank instantaneous correlation structure

i,j = + (1 )e|ji| ,

with = 0.2 implying 1,2 = 0.9.

h) With instantaneous correlations as in g) and volatilities as in e),

compute the terminal correlation matrix in three years (at time T2 ) and

say whether it looks acceptable.

64 / 143

EXERCISES

SOLUTION:

a) We know that the T0 T1 caplet volatility in the LIBOR model is v0 ,

where

Z T0

Z

1 1y 2

1

2

2

v0 =

1 (t) dt =

1 dt = 12 ,

T0 0

1 0

so that 1 = v0 = 0.1.

Similarly, the T1 T2 caplet volatility is v1 , where

v12

1

= (

2

1y

Z 2y

Z T1

1

1

2

(

(

2 (t)2 dt) =

=

2 (t) dt) =

T1 0

2y 0

2

2y

2 (t) dt +

0

1y

Z 2y

Z

1 1y 2

2 (t) dt) = (

12 dt)

2 dt +

2 0

1y

=

(c) 2012-13 D. Brigo (www.damianobrigo.it)

1 2

( + 22 ),

2 1

65 / 143

EXERCISES

from which

2 =

2v12 12 = 0.1371

Then, analogously,

v22 =

and

3 =

1 2

( + 22 + 12 )

3 3

q

3v2 22 12 = 0.1967,

and similarly

4 = 0.1044, 5 = 0.0781,

6 = 0.0436.

b). With v5 = 0.08 we follow the same procedure, but when we reach

q

6 = 6v52 52 42 32 22 12 = 0.0461 =

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EXERCISES

= 0.2147i

the square root of a negative number, i.e. an imaginary number,

unacceptable as a volatility. Then in this case the chosen

parameterization of volatilities cannot be calibrated to caplet volatilities.

c) As before, we know that the T0 T1 caplet volatility in the LIBOR

model is v0 , where

v02

1

=

T0

Z

0

T0

1

1 (t) dt =

1

2

1y

21 dt = 21 ,

so that 1 = v0 = 0.1.

Similarly, the T1 T2 caplet volatility is v1 , where

v12

Z T1

Z 2y

1

1

2

=

(

2 (t) dt) =

(

2 (t)2 dt) =

T1 0

2y 0

67 / 143

EXERCISES

=

1

(

2

1y

2 (t)2 dt +

2y

1y

2 (t)2 dt) =

1

(

2

1y

Z

0

22 dt +

2y

1y

22 dt)

1

(222 ) = 22 ,

2

from which

2 = v1 = 0.12

Then, analogously,

v22 =

1 2

( + 23 + 23 )

3 3

and

3 = v2 = 0.15,

and similarly

4 = v3 = 0.14, 5 = v4 = 0.13,

(c) 2012-13 D. Brigo (www.damianobrigo.it)

6 = v5 = 0.12

Imperial College London

68 / 143

EXERCISES

d) This time v5 = 0.08 gives no problem, since 6 = v5 = 0.08 is fine.

The parameterization never breaks down if the input caplet

volatilities make sense, whereas the parameterization can give

problems for steep caplet volatility graphs, as seen in case b) above.

e) By carrying out multiplications, i ([Tk1 , Tk )) = i ik , as in

Inst. Vols

Fwd : F1 (t)

F2 (t)

..

.

FM (t)

t (0, T0 ]

1 1

2 2

(T0 , T1 ]

Dead

2 1

(T1 , T2 ]

Dead

Dead

...

...

...

(TM2 , TM1 ]

Dead

Dead

...

M M

...

M M1

...

M M2

...

...

...

M 1

0.1

0.132

0.144

0.081

0.064

0.121

0.11

0.144

0.108

0.072

0.088

0.12

0.108

0.096

0.099

0.09

0.096

0.132

0.08

0.132

0.11

69 / 143

EXERCISES

Then

v12

Z T1

Z 2y

1

1

2

(

(

=

2 (t) dt) =

2 (t)2 dt) =

T1 0

2y 0

Z

Z 2y

1 1y

2

= (

2 (t) dt +

2 (t)2 dt) =

2 0

1y

Z

Z 2y

1 1y

2

= (

(2 2 ) dt +

(2 1 )2 dt)

2 0

1y

or, basically, the sum of the squares of the elements in the second row

of the above matrix, each squared being multiplied by the relevant year

fraction (1y in this case):

v12 =

1

(1 0.1322 + 1 0.112 ) = 0.01476, v1 = 0.1215

2

70 / 143

EXERCISES

Similarly, v22 is obtained by adding up the squares of the third row and

dividing by 3:

v22 =

1

(1 0.1442 + 1 0.1442 + 1 0.122 ) = 0.01862, v2 = 0.13646

3

and so on.

f) Term structure of caplet volatilities in one year, i.e. at T0 = 1y . From

the formula in an earlier Lecture:

Z Th1

1

2

V (T0 , Th1 ) =

h2 (t)dt, h > 1.

Th1 T0 T0

In particular,

1

V (T0 , T1 ) =

T1 T0

2

T1

T0

22 (t)dt

1

=

1

2y

1y

22 (t)dt =

71 / 143

EXERCISES

Z

2y

(2 1 )2 dt = (2 1 )2 = (0.11)2

1y

1

V (T0 , T2 ) =

T2 T0

2

T2

T0

32 (t)dt

Z

1 3y 2

= (

(t)dt) =

2 1y 3

Z

Z 3y

1 2y 2

= (

(t)dt +

32 (t)dt) =

2 1y 3

2y

Z

Z 3y

1 2y

2

= (

(3 2 ) dt +

(3 1 )2 dt) =

2 1y

2y

=

1

((3 2 )2 + (3 1 )2 ) = 0.01757

2

72 / 143

EXERCISES

so that V (T0 , T2 ) = 0.132544. Similarly,

V (T0 , T3 ) = 0.1023, V (T0 , T4 ) = 0.0866, V (T0 , T5 ) = 0.1136

This completes the term structure of caplets volatilities in one year, i.e.

at T0 .

0.11, 0.1325, 0.1023, 0.0866, 0.1136

Notice: it is enough to add the squares (times the relevant year

fraction) in each row of the ziggurat matrix up to the end, starting

from the second column, then dividing by the number of years and

taking square roots. Fast and simple in excel.

For the term structure in two years, i.e. at T1 = 2y , the exercise is

similar:

Z T2

Z

1

1 3y 2

V 2 (T1 , T2 ) =

32 (t)dt =

(t)dt =

T2 T1 T1

1 2y 3

(c) 2012-13 D. Brigo (www.damianobrigo.it)

73 / 143

EXERCISES

Z

3y

(3 1 )2 dt = (3 1 )2 = (0.12)2

2y

1

V (T1 , T3 ) =

T3 T1

2

T3

T1

42 (t)dt

Z

1 4y 2

= (

(t)dt) =

2 2y 4

Z

Z 4y

1 3y 2

= (

(t)dt +

42 (t)dt) =

2 2y 4

3y

Z

Z 4y

1 3y

2

= (

(4 2 ) dt +

(4 1 )2 dt) =

2 2y

3y

=

1

((4 2 )2 + (4 1 )2 ) = 0.009882

2

74 / 143

EXERCISES

so that V (T1 , T3 ) = 0.0994.

1

V (T1 , T4 ) =

T4 T1

2

T4

T1

52 (t)dt

Z

1 5y 2

(t)dt) =

= (

3 2y 5

Z

Z 4y

Z 5y

1 3y 2

2

= (

(t)dt +

5 (t)dt +

52 (t)dt) =

3 2y 5

3y

4y

Z 3y

Z 4y

Z 5y

1

2

2

(5 3 ) dt +

(5 2 ) dt +

(5 1 )2 dt) =

= (

3 2y

3y

4y

1

((5 3 )2 + (5 2 )2 + (5 1 )2 ) = 0.008277333

3

so that V (T1 , T4 ) = 0.09098. And so on, with V (T1 , T5 ) = 0.11911.

The term structure of caplet volatilities in 2y (at time T1 ) is

=

(c) 2012-13 D. Brigo (www.damianobrigo.it)

75 / 143

EXERCISES

Notice that it is enough to add the squares (times the relevant year

fraction) in each row of the ziggurat matrix up to the end, starting

from the third column, then dividing by the number of years and taking

square roots. Very fast in excel.

The term structure in three years is computed similarly:

0.09, 0.099363, 0.1251

and in Four years:

0.08, 0.1215

while, finally, in five years we just have V (T4 , T5 ) = 0.11.

g) If = 0.2, then

1,2 = + (1 )e|21| = + (1 )e0.2 .

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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EXERCISES

Since we know that 1,2 = 0.9, we solve

0.9 = + (1 )e0.2

in . We obtain = 0.4483.

h). To compute the terminal correlations in three years (time T2 ) we

use the formula

R T2

i (t)j (t) dt

.

qR

T2 2

T2 2

0 i (t)dt

0 j (t)dt

Let us compute for example Corr(F3 (T2 ), F5 (T2 )), given by the above

formula with i = 3 and j = 5. We need

3,5 = + (1 )e|53| = 0.4483 + (1 0.4483)0.6703

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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EXERCISES

= 0.8181

Compute the numerator:

3y

1y

Z

3 (t)5 (t) dt =

0

2y

3y

Z

3 (t)5 (t) dt +

+

1y

3 (t)5 (t) dt =

2y

1y

2y

3 3 5 5 dt +

=

0

3 2 5 4 dt+

1y

3y

3 1 5 3 dt =

+

2y

= 3 3 5 5 + 3 2 5 4 + 3 1 5 3 =

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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EXERCISES

By substituting from the above ziggurat matrix we get = 0.0311. Again,

it is faster to multiply the corresponding terms in the third and fifth rows

of the ziggurat up to the third column included to get a faster

evaluation:

0.144 0.064 + 0.144 0.072 + 0.12 0.096.

RT

Let us compute the denominators. Notice that 0 2 32 (t)dt is three

times the squared T2 T3 caplet volatility, which is v22 as computed in

RT

point e). We get 0 2 32 (t)dt = 3v22 = 3 0.01862 = 0.05586. Take

square root to get 0.2363 as the first term in the denominator. For the

second term, we need to compute

Z

0

(c) 2012-13 D. Brigo (www.damianobrigo.it)

3y

52 (t)dt

79 / 143

EXERCISES

It is enough to sum the squares (times the relevant year fractions) of

the fifth row (i.e. 5 ) in the ziggurat matrix of point e) up to the third

column (i.e. up to three years) included. We get

Z

0

3y

Corr(F3 (T2 ), F5 (T2 )) = 0.8181

0.0311

= 0.7917

0.2363 0.136

Once you have computed the other terminal correlations in three years

and formed the matrix, you check whether the columns are decreasing

when moving away from the diagonals. You also check there are no

negative entries.

(c) 2012-13 D. Brigo (www.damianobrigo.it)

80 / 143

EXERCISES

Assume that, following calibration to CDS, we have a piecewise

constant hazard rare (t) that takes the following values.

(t) = 0.02 for 0 <= t < 1y

(t) = 0.04 for 1y <= t < 2y

(t) = 0.02 for 2y <= t < 3y

Compute:

a) The probability of defaulting in one year, two years and three years.

b) The probability of surviving in two years.

c) assuming that the recovery is 0.5, interest rates are zero and the

CDS sells protection from today to three years, compute the price of

the default or protection leg of the CDS.

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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EXERCISES

Solutions.

a) Probability of default in T year is

T

Z

Q( T ) = 1 exp(

(t)dt) =?

0

Compute

1

(t)dt =

0

Compute

Z

Z

(t)dt =

Z

(t)dt +

Z

0.02dt +

(t)dt =

0

0.04dt =

1

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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EXERCISES

Analogously,

Z

0

respectively as

1 exp(0.02), 1 exp(0.06), 1 exp(0.08)

b) The probability of surviving in two years is

Z

Q( > T ) = exp(

(t)dt)

0

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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EXERCISES

interest rates are zero, r = 0, all discounts are equal to one,

D(s, u) = exp(r (u s)) = exp(0) = 1. Hence we have

= LGD(1exp(0.08)) = (1REC)(1exp(0.08)) = 0.5(1exp(0.08))

84 / 143

EXERCISES

Assume we are given a stochastic intensity process of CIR type,

where y0 , , , are positive constants. W is a brownian motion under

the risk neutral measure.

a) Increasing increases or decreases randomness in the intensity?

And ?

b) The mean of the intensity at future times is affected by k? And by ?

c) What happens to mean of the intensity when time grows to infinity?

d) Is it true that, because of mean reversion, the variance of the

intensity goes to zero (no randomness left) when time grows to infinity?

(c) 2012-13 D. Brigo (www.damianobrigo.it)

85 / 143

EXERCISES

in the intensity?

f) Suppose that y0 = 400bps = 0.04, = 0.3, = 0.001 and

= 400bps. Can you guess the behaviour of the future random

trajectories of the stochastic intensity after time 0?

g) Can you guess the spread of a CDS with 10y maturity with the

above stochastic intensity when the recovery is 0.35?

86 / 143

EXERCISES

SOLUTIONS.

a) We can refer to the formulas for the mean and variance of yT in a

CIR model as seen from time 0, at a given T . The formula for the

variance is known to be (see course slides or, for example, Brigo and

Mercurio (2006))

VAR(yT ) = y0

2 T

2

(e

e2T ) + (1 eT )2

E[yT ] = y0 eT + (1 eT )

We can see that for k becoming large the variance becomes small,

since the exponentials decrease in k and the division by k gives a

small value for large k. In the limit

(c) 2012-13 D. Brigo (www.damianobrigo.it)

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lim VAR(yT ) = 0

We can instead see that VAR(yT ) is proportional to 2 , so that if

instantaneous volatility in the process y.

b) As the mean is

E[yT ] = y0 eT + (1 eT )

we clearly see that this is impacted by (indeed, speed of mean

reversion) and by clearly (long term mean) but not by the

instantaneous volatility parameter .

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EXERCISES

lim y0 eT + (1 eT ) =

T +

so that the mean tends to (this is why is called long term mean).

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d) In the limit where time goes to infinity we get, for the variance

lim [y0

T +

2 T

2

2

(e

e2T ) + (1 eT )2 ] =

2

2

So this does not go to zero. Indeed, mean reversion here implies that

as time goes to infinite the mean tends to and the variance to the

2

constant value 2

, but not to zero.

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e) Rough approximations of the percentage volatilities in the intensity

would be as follows. The instantaneous variance in dyt , conditional on

the information up to t, is (remember that VAR(dW (t)) = dt)

VAR(dyt ) = 2 yt dt

The percentage variance is

dyt

2

2 yt

VAR

dt

= 2 dt =

yt

yt

yt

and is state dependent, as it depends on yt . We may replace yt with

either its initial value y0 or with the long term mean , both known. The

two rough percentage volatilities estimates will then be, for dt = 1,

s

s

2

= ,

=

y0

y0

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EXERCISES

the overall volatility of finite (as opposed to instantaneous) credit

spreads and are therefore relatively useless.

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f) First we check if the positivity condition is met.

2 = 2 0.3 0.04 = 0.024;

2 = 0.0012 = 0.000001

the variance is very small: Take T = 5y ,

VAR(yT ) = y0

2 T

2

(e

e2T ) + (1 eT )2 0.0000006.

Take the standard deviation, given by the square root of the variance:

which is much smaller of the level 0.04 at which the intensity refers

both in terms of initial value and long term mean. Therefore there is

almost no randomness in the system as the variance is very small

compared to the initial point and the long term mean.

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EXERCISES

y0 is the same as the long term mean = 0.04, the intensity will

behave as if it had the value 0.04 all the time. All future trajectories will

be very close to the constant value 0.04.

g) In a constant intensity model the CDS spread can be approximated

by

y=

RCDS

RCDS = y (1 REC) = 0.04(1 0.35) = 260bps

1 REC

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EXERCISES

Consider a default-free zero coupon bond with final maturity T in a

market with constant-in-time and random interest rates r that are

uniformly distributed in [0, R]. Assume interest rates are independent

of the default time of the counterparty.

Denote by P(t, T ) the price of the bond at time t for maturity T .

Assume that the bond portfolio is held at time t by a party A and that

the payment of the notional 1 at maturity T is expected from a

counterparty C.

Assume further that the probability of default of C is associated to an

intensity model with random intensity that is constant in time and

uniformly distributed in the interval [0, L]. Clearly, is independent of r .

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EXERCISES

a) Compute the Credit Valuation Adjustment (CVA) for the price of the

bond as seen from A.

b) Compute the CVA sensitivity

CVA

R

to the interest rates range R.

c) Compute the CVA limit when the intensity range contracts to 0,

namely L 0, and comment your finding.

d) Compute the CVA limit when the interest rates range contracts to 0,

namely R 0, and comment your finding.

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EXERCISES

longer assume r to be uniformly distributed. Instead, we assume that

the instantaneous interest rate r now follows a Vasicek process

drt = k( rt )dt + dWr (t),

r0

motion under the risk neutral measure and is independent of .

f) Briefly discuss as we could modify the setup in point e) above to

include wrong way risk analysis.

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EXERCISES

Solution.

a). We compute

CVA = (1 Rec)E0 [1{ <T } D(0, )(NPV( ))+ ] =

where NPV ( ) is the residual NPV of the bond at the default time of

the counterparty. The residual NPV in our case is the residual value of

the bond at time for maturity T , which is P(, T ).

CVA = (1 Rec)E0 [1{ <T } D(0, )(P(, T ))+ ] =

Since a zero coupon bond price is always positive, the positive part

(...)+ can be removed without affecting our equation:

= (1 Rec)E0 [1{ <T } D(0, )P(, T )] =

Remembering the general definition of zero coupon bond price, namely

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P(t, T ) = Et [D(t, T )], we have

= (1 Rec)E0 [1{ <T } D(0, )E [D(, T )]] =

Since D(0, ) is measurable for E , we can bring it inside the expected

value:

= (1 Rec)E0 [1{ <T } E [D(0, )D(, T )]] =

= (1 Rec)E0 [1{ <T } E [D(0, T )]] =

where we have used D(0, s)D(s, t) = D(0, t). Then we notice that also

1{ <T } is measurable for E , and hence can be brought inside the

expected value

= (1 Rec)E0 [E [1{ <T } D(0, T )]] =

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Now we use the tower property of conditional expectation:

E0 [E [X ]] = E0 [X ], so that

= (1 Rec)E0 [1{ <T } D(0, T )] = (1 Rec)Q( < T )E0 [D(0, T )] =

where we have used independence of and D(0, T ), which follows

from the independence of r and . We obtain

= (1 Rec)Q( < T )P(0, T )

Hence to compute CVA we just need to compute Q( < T ) and

P(0, T ).

We start from

Z

Q{ T } = E[exp(

t dt)] = E[exp(T )] =

0

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EXERCISES

since in our case is constant in time. Then

Z L

Z L

1

1

=

exp(xT )p (x)dx =

exp(xT ) dx =

(1 exp(LT ))

L

LT

0

0

where we have used the fact that is uniformly distributed (with

density 1/L) in [0, L]. Then Q{ < T } = 1 Q{ T } above.

The bond price is similarly computed:

Z

P(0, T ) = E0 [exp(

rt dt)] = E0 [exp(rT )] =

0

where we have used the fact that interest rates are constant. We get

Z

=

0

1

1

exp(xT ) dx =

(1 exp(RT ))

R

RT

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EXERCISES

where the calculation is completely analogous to the one for .

By substituting the above expressions we finally obtain the CVA

formula

1

1

CVA = (1 REC) 1

(1 exp(LT ))

(1 exp(RT ))

LT

RT

b)

Set

1

A(L) := (1 REC) 1

(1 exp(LT )) .

LT

B(R) :=

1

(1 exp(RT )).

RT

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EXERCISES

A(L) is the part of CVA that does not depend on R. CVA is given by

CVA = A(L) B(R) = A(L)

1

(1 exp(RT )).

RT

CVA

1

= A(L) 2 (RT exp(RT ) + exp(RT ) 1)

R

R T

c)

When L 0 we can compute the limit

lim A(L)B(R) = B(R) lim A(L) =

L0

L0

1

= B(R)(1 REC) lim 1

(1 exp(LT ))

LT

L0

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EXERCISES

1

= B(R)(1 REC) 1 lim

(1 exp(LT )) =

L0 LT

Now we can use well known limits of the exponential function, or

expand the exponential function in Taylor series around 0, or again use

De LHopital. In any case we obtain

= B(R)(1 REC)(1 1) = 0.

This result is natural: If the uniform distribution of collapses towards

0, given that dt is the local probability of default around [t, t + dt) for

all t, it follows that when L 0 one has zero probability of defaulting

around [t, t + dt) for all ts. Hence default cannot happen with zero

intensity and CVA is zero because we are pricing counterparty default

risk in a situation where default cannot happen.

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EXERCISES

d)

When R 0 we can compute the limit

lim A(L)B(R) = A(L) lim B(R) =

R0

R0

1

(1 exp(RT )) =

R0 RT

= A(L) lim

expand the exponential function in Taylor series around 0, or again use

De LHopital. In any case we obtain

= A(L)1 = A(L)

This is also natural. If interest rates collapse to zero, with R going to

zero, then the zero coupon bond will be worth 1 whatever the maturity.

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EXERCISES

Hence CVA reduces to the probability of default times (1-REC), given

that the residual value of the bond will be 1 regardless of when default

happens.

e) In the Vasicek case for r , given that r is still independent of , all

steps done in point a) until

... to compute CVA we just need to compute Q( < T ) and P(0, T )

are still valid. We still have

CVA = (1 Rec)Q( < T )P(0, T )

except that now P(0, T ) will be the bond price given by the Vasicek

model, namely

P(0, T ) = A(0, T ) exp(B(0, T )r0 )

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EXERCISES

(write the expressions for A and B from the lectures and write the final

CVA total formula).

f)

To introduce wrong way risk, we need to introduce dependence

between the default event and the Bond underlying interest rates. To

do that, we need to correlate and r . Since we are in an intensity

framework, we need to correlate a possibly random intensity to interest

rates.

A possible way to do that would be to use a CIR++ model for the

intensity: define the default intensity t of the counterparty as

t = yt + (t)

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EXERCISES

where y follows a CIR modela and is a positive deterministic shift

used to fit exactly market implied default probabilities coming either

from CDS or Defaultable Bonds.

If we assume y follows a CIR dynamics under the risk neutral

probability measure Q, we can write

Now to correlate intensity and rates we introduce a non-null quadratic

covariation between Wr and Wy , namely

dhWr , Wy it = dt.

This creates a link between r and . If is negative, then when the

intensity increases, making default more likely1 , r will tend to

decrease, due to the negative correlation. When r decreases, the

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EXERCISES

Bond price P increases. Let us take the extreme case and set

correlation to = 1. We have

P CVA Amplified.

Due to the totally negative correlation, when increases and default

becomes more likely, we have that the bond increases too, so that the

option embedded in the CVA payoff goes more in the money. Hence

CVA will be bigger due to the effect of correlation. This means that in

this case wrong way risk is given by correlation = 1.

not having defaulted earlier

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EXERCISES

Consider a call option C with final maturity T on a default-free equity

stock S in a market with constant and deterministic interest rate r .

Assume the stock S follows a geometric brownian motion with volatility

under the risk neutral measure and with initial value S0 at time 0.

Assume that the call portfolio is held at time t by a party A and, if the

option is exercised, the underlying S will be delivered at maturity T by

a counterparty C at the agreed strike price K .

Assume further that the probability of default of C is associated to an

intensity model with random intensity that is constant in time and

uniformly distributed in the interval [0, L]. Assume is independent of

the stock price S. The recovery rate associated to default of C is

assumed to be a deterministic constant REC.

Compute the Credit Valuation Adjustment (CVA) for the price of the call

as seen from A.

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EXERCISES

Solution.

We compute

CVA = (1 Rec)E0 [1{ <T } D(0, )(NPV( ))+ ] =

where NPV ( ) is the residual NPV of the call at the default time of

the counterparty. The residual NPV in our case is the expected value

at time of the discounted payoff of the call, which is

NPV( ) = E [D(, T )(ST K )+ ].

CVA = (1 Rec)E0 [1{ <T } D(0, )(E [D(, T )(ST K )+ ])+ ] =

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EXERCISES

Since the discount factor and the payoff of a call are always positive,

the outer positive part (...)+ can be removed without affecting our

equation:

= (1 Rec)E0 [1{ <T } D(0, )E [D(, T )(ST K )+ ]]

= (1 Rec)E0 [1{ <T } E [D(0, )D(, T )(ST K )+ ]]

= (1 Rec)E0 [1{ <T } E [D(0, T )(ST K )+ ]] =

where we also used the fact that D(0, ) is measurable for E and the

property D(0, s)D(s, t) = D(0, t). Now, noticing that 1{ <T } is also

measurable for E we can then apply the tower property of conditional

expectation E0 [E [X ]] = E0 [X ]

= (1 Rec)E0 [E [1{ <T } D(0, T )(ST K )+ ]] =

= (1 Rec)E0 [1{ <T } D(0, T )(ST K )+ ] =

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EXERCISES

We assume independence of and S,

= (1 Rec)E0 [1{ <T } ]E0 [D(0, T )(ST K )+ ] =

= (1 Rec)Q( < T ) CallPrice0 .

Hence, to compute CVA we just need to compute Q( < T ), and the

call price at t = 0. We already know from the previous exercise that

Q( < T ) = 1

1

(1 exp(LT ))

LT

CallPrice0 = S0 N(d1 ) KerT N(d2 )

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EXERCISES

where

ln(S0 /K ) + (r + 2 /2)T

p

(T )

p

d2 = d1 (T )

d1 =

formula

1

CVA = (1 REC) 1

(1 exp(LT )) (S0 N(d1 ) KerT N(d2 ))

LT

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EXERCISES

Consider two default-free zero coupon bond withs final maturities T1

and T2 = T , respectively, T1 < T2 , in a market with interest rates that

are independent of credit and default risk.

Denote by P(t, T ) the price of a default-free bond at time t for maturity

T.

Assume that the bonds are held at time t by a bank B and that the

payment of the notionals 1 at maturities T1 and T2 is expected from a

counterparty C.

Try to answer all questions below in terms of default probabilities,

recovery rates, and zero coupon bond prices P(0, Ti ). If at some point

you need information that is not in this dataset, please specify at that

point what further information you would need.

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EXERCISES

a) Compute the total Credit Valuation Adjustment (CVA) seen from the

Bank for the two bonds position, assuming that they are not in a netting

agreement with C.

b) Compute the total Credit Valuation Adjustment (CVA) seen from the

Bank for the two bonds position, assuming that they are in a netting

agreement with C.

c) Comment on the differences between a) and b).

d) Repeat points a), b) and c) but in case now we have the following

two bond positions: Short one bond with maturity T1 , long one bond

with maturity T2 .

e) Repeat points a), b) and c) but in case now we have the following

two bond positions: Long one bond with maturity T1 , short one bond

with maturity T2 .

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EXERCISES

Solution.

a). If there is no netting agreement, the losses on the two positions,

due to default risk, are to be priced separately, and then they are

added up.

We need then to compute CVA for the first bond and CVA for the

second bond, and add them up.

We have seen in a previous exercise that the price of CVA at time 0 for

a zero coupon default-free bond with maturity T is

CVA = (1 Rec)Q( < T )P(0, T ).

This formula is derived exactly in the same way as before. It is enough

to assume that interest rates and default are independent for this

formula to hold (rederive the formula and check this). Hence it holds

also in this case. The total CVA for the two bonds is then

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EXERCISES

CVATOT = CVA1 + CVA2 ,

By substituting the default probabilities formulas derived in the earlier

exercise for the uniform intensity case, we conclude.

b) If there is a netting agreement, the residual values on the two

positions are to be netted at default, before checking positivity.

It is best to write the discounted cash flows of the netted portfolio at a

time t < T2 : we obtain, recalling that T = T2 ,

(t, T ) = 1tT1 D(t, T1 ) 1 + D(t, T2 ) 1.

In other terms, we need to take into account that after T1 , the first bond

expires, and the notional is paid back. Hence it makes a difference

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EXERCISES

whether we are looking at a case before T1 or after T1 . Before T1 we

have two bond positions, after T1 we only have one, namely the T2

maturity bond.

We compute the CVA of the two bond positions under netting as

follows:

CVA = (1 Rec)E0 [1{ <T } D(0, )(E [(, T )])+ ] = ...

Now we pause a second to compute

E [(, T )] = E [1 T1 D(, T1 ) 1 + D(, T2 ) 1] =

= 1 T1 E [D(, T1 ) 1] + E [D(, T2 ) 1] = 1 T1 P(, T1 ) + P(, T2 ) 0,

where we have used the fact that 1 T1 is E -measurable, and the

definition of zero coupon bond price. We see that the residual NPV is

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EXERCISES

always non-negative, given that it is the sum of two positive zero

coupon bonds. It follows that

(E [(, T )])+ = (1 T1 P(, T1 )+P(, T2 ))+ = 1 T1 P(, T1 )+P(, T2 )

so that, going back to our CVA calculation, writing LGD = 1-Rec,

... = (1 Rec)E0 [1{ <T } D(0, )(1 T1 P(, T1 ) + P(, T2 ))] =

= LGD E0 [1{ <T } D(0, )1 T1 P(, T1 )]+LGD E0 [1{ <T } D(0, )P(, T2 ))] =

= LGD E0 [1{ <T1 } D(0, )P(, T1 )]+LGD E0 [1{ <T } D(0, )P(, T2 ))] = ...

where we have used the fact that

1{ <T1 } 1{ <T2 } = 1{ <T1 } .

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EXERCISES

The second expected value is the CVA on a single T2 bond position,

and is the same as the CVA2 we found in point a) above.

We can pause for a second to make the first expected value explicit, as

we have already done earlier:

E0 [1{ <T1 } D(0, )(E (D(, T1 )))] = E0 [E (1{ <T1 } D(0, )D(, T1 ))] =

= E0 [E (1{ <T1 } D(0, T1 ))] = E0 [1{ <T1 } D(0, T1 )] = Q( < T1 )P(0, T1 )

where we have used the tower property of expectations and the

independence between default and interest rates discounts D(0, T1 ).

Putting all the pieces together:

... = LGD Q( < T1 )P(0, T1 ) + LGD E0 [1{ <T } D(0, )P(, T2 ))]

So we conclude

CVANETTING = CVA1 + CVA2

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EXERCISES

exactly as in the previous case a).

c) There is no difference between a) and b). The reason is that, being

the NPV of the two assets positive or zero in all scenarios, and never

negative, the two asset values never offset each other. There is no

scenario where one asset is positive and the other one is negative,

giving some benefit to netting. Hence netting is irrelevant here.

d)

We restart from a), and call this d.a)

d.a) If there is no netting agreement, the losses on the two positions,

due to default risk, are to be priced separately, and then they are

added up.

We need then to compute CVA for the first (short) bond and CVA for

the second (long) bond, and add them up.

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EXERCISES

For the second (long) bond, we still have

CVA = (1 Rec)Q( < T2 )P(0, T2 ) = CVA2 .

This formula is derived exactly in the same way as before. For the first

(short) bond, the price of the position E [(, T )] at default time is

P(, T1 )

0

if

T1 ,

if

Then the residual NPV is always negative or zero for the first bond, so

that when we take its positive part,

(E [(, T )])+ = (P(, T1 )1{ T1 } )+ = 0,

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EXERCISES

so that the CVA for the first bond position is zero, since the positive

part of the residual NPV is zero in all scenarios. So in this case

CVATOT = CVA2 .

d.b)

If there is a netting agreement, the residual values on the two positions

are to be netted at default, before checking positivity.

It is best to write the discounted cash flows of the netted portfolio at a

time t < T2 : we obtain, recalling that T = T2 ,

(t, T ) = 1tT1 D(t, T1 ) 1 + D(t, T2 ) 1.

The first bond, with maturity T1 , has a minus because we are in a short

position in that bond. The second bond has a plus because we are in a

long position.

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EXERCISES

In other terms, we need to take into account that after T1 , the first bond

expires. Hence it makes a difference whether we are looking at a case

before T1 or after T1 . Before T1 we have two bond positions, after T1

we only have one, namely the T2 maturity bond.

We compute the CVA of the two bond positions under netting as

follows:

CVA = (1 Rec)E0 [1{ <T } D(0, )(E [(, T )])+ ] = ...

Now we pause a second to compute

E [(, T )] = E [1 T1 D(, T1 ) 1 + D(, T2 ) 1] =

= 1 T1 E [D(, T1 ) 1] + E [D(, T2 ) 1] = 1 T1 P(, T1 ) + P(, T2 ),

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where we have used the fact that 1 T1 is E -measurable, and the

definition of zero coupon bond price. It follows that

(E [(, T )])+ = (1 T1 P(, T1 ) + P(, T2 ))+ =

= (1 T1 P(, T1 ) + (1 T1 + 1 >T1 )P(, T2 ))+ =

= (1 T1 (P(, T1 ) P(, T2 )) + 1 >T1 P(, T2 ))+

This last expression can take two different values depending on

whether T1 or > T1 . We see that

(E [(, T )])+ = (P(, T1 ) + P(, T2 ))+ = 0 if T1

(E [(, T )])+ = (P(, T2 ))+ = P(, T2 ) if > T1 .

The first row 0 is due to the fact that a zero coupon bond with a

shorter maturity is always worth more than a zero coupon bond with a

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EXERCISES

longer maturity, as we get the money back earlier. Hence

P(, T1 ) > P(, T2 ), which also implies P(, T2 ) P(, T1 ) < 0 and

hence (P(, T2 ) P(, T1 ))+ = 0.

We can write this in a single equation as

(E [(, T )])+ = 1{ >T1 } P(, T2 ).

Going back to our CVA calculation, writing LGD = 1-Rec,

... = LGD E0 [1{ <T } D(0, )1{ >T1 } P(, T2 )] =

= LGD E0 [1{T1 <T2 } D(0, )P(, T2 ) = ...

where we have used 1{ <T } 1{ >T1 } = 1{ <T2 } 1{ >T1 } = 1{T1 < <T2 } .

We continue as usual

... = LGD E0 [1{T1 < <T2 } D(0, )E [D(, T2 )]] =

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= LGD E0 [E [1{T1 < <T2 } D(0, )D(, T2 )]] =

= LGD E0 [E [1{T1 < <T2 } D(0, T2 )]] = LGD E0 [1{T1 < <T2 } D(0, T2 )] =

= LGD E0 [1{T1 < <T2 } ]E0 [D(0, T2 )] = LGD Q{T1 < < T2 }P(0, T2 ) =

= LGD(Q{ < T2 } Q{ < T1 })P(0, T2 ) =

= CVA2 LGD Q{ < T1 }P(0, T2 ).

We conclude

CVANETTING = CVA2 LGD Q{ < T1 }P(0, T2 ).

d.c) There is now a relevant difference between d.a) and d.b). The

reason is that now the two assets offset each other in several

scenarios. When default happens before T1 , the short T1 bond has a

negative value that dominates, in absolute value, the positive bond T2 .

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EXERCISES

Hence the total NPV in this case is negative and there is no

contribution to the CVA payoff. When instead default happens after T1

and before T2 , the first bond is gone and we only have the second

(positive) bond T2 , which is not offset by any other cash flow.

Therefore netting benefits us only in scenarios where default is before

T1 . This is confirmed if we compute the difference between CVATOT

and CVANETTING , giving us the price benefit of netting:

CVATOT CVANETTING = CVA2 (CVA2 LGD Q{ < T1 }P(0, T2 )) =

= LGD Q{ < T1 }P(0, T2 ).

This is the netting benefit.

129 / 143

EXERCISES

e)

We restart from a), and call this e.a)

e.a) If there is no netting agreement, the losses on the two positions,

due to default risk, are to be priced separately, and then they are

added up.

We need then to compute CVA for the first (long) bond and CVA for the

second (short) bond, and add them up.

For the first (short) bond, we still have

CVA = (1 Rec)Q( < T1 )P(0, T1 ) = CVA1 .

This formula is derived exactly in the same way as before. For the

second (short) bond, similarly to what we have seen in d.a), we see

130 / 143

EXERCISES

that the residual value at default is always negative, so that this yields

a zero CVA. So in this case

CVATOT = CVA1 .

e.b)

If there is a netting agreement, the residual values on the two positions

are to be netted at default, before checking positivity.

It is best to write the discounted cash flows of the netted portfolio at a

time t < T2 : we obtain, recalling that T = T2 ,

(t, T ) = 1tT1 D(t, T1 ) 1 D(t, T2 ) 1.

The second bond, with maturity T2 , has a minus because we are in a

short position in that bond. The first bond has a plus because we are

in a long position.

(c) 2012-13 D. Brigo (www.damianobrigo.it)

131 / 143

EXERCISES

In other terms, we need to take into account that after T1 , the first bond

expires. Hence it makes a difference whether we are looking at a case

before T1 or after T1 . Before T1 we have two bond positions, after T1

we only have one, namely the T2 maturity bond.

We compute the CVA of the two bond positions under netting as

follows:

CVA = (1 Rec)E0 [1{ <T } D(0, )(E [(, T )])+ ] = ...

Now we pause a second to compute

E [(, T )] = E [1 T1 D(, T1 ) 1 D(, T2 ) 1] =

= 1 T1 E [D(, T1 ) 1] E [D(, T2 ) 1] = 1 T1 P(, T1 ) P(, T2 ),

132 / 143

EXERCISES

where we have used the fact that 1 T1 is E -measurable, and the

definition of zero coupon bond price. It follows that

(E [(, T )])+ = (1 T1 P(, T1 ) P(, T2 ))+ =

= (1 T1 P(, T1 ) (1 T1 + 1 >T1 )P(, T2 ))+ =

= (1 T1 (P(, T1 ) P(, T2 )) 1 >T1 P(, T2 ))+

This last expression can take two different values depending on

whether T1 or > T1 . We see that

(E [(, T )])+ = (P(, T1 ) P(, T2 ))+ if T1

(E [(, T )])+ = (P(, T2 ))+ = 0 if > T1 .

133 / 143

EXERCISES

This is the same as

(E [(, T )])+ = P(, T1 ) P(, T2 ) if T1

(E [(, T )])+ = (P(, T2 ))+ = 0 if > T1

because the positive part in the first row is not acting. Indeed, the

difference P(, T1 ) P(, T2 ) is already positive in all scenarios, as it is

the difference of a more valuable bond with a less valuable one, as we

explained earlier in d.b).

We can write this in a single equation as

(E [(, T )])+ = 1{ <T1 } (P(, T1 ) P(, T2 )).

Going back to our CVA calculation, writing LGD = 1-Rec,

... = LGD E0 [1{ <T } D(0, )1{ <T1 } (P(, T1 ) P(, T2 ))] =

(c) 2012-13 D. Brigo (www.damianobrigo.it)

134 / 143

EXERCISES

= LGD E0 [1{ <T1 } D(0, )(P(, T1 ) P(, T2 ))] =

= LGD E0 [1{ <T1 } D(0, )E [D(, T1 ) D(, T2 )]] =

= LGD E0 [1{ <T1 } E [D(0, )D(, T1 ) D(0, )D(, T2 )]] =

= LGD E0 [1{ <T1 } E [D(0, T1 ) D(0, T2 )]] =

= LGD E0 [E [1{ <T1 } (D(0, T1 ) D(0, T2 ))]] =

= LGD E0 [1{ <T1 } (D(0, T1 ) D(0, T2 ))] =

= LGD E0 [1{ <T1 } ] E0 [D(0, T1 ) D(0, T2 )] =

= LGD Q{ < T1 }[P(0, T1 ) P(0, T2 )].

We conclude CVANETTING = LGD Q{ < T1 }[P(0, T1 ) P(0, T2 )] =

= CVA1 LGD Q{ < T1 }P(0, T2 ).

(c) 2012-13 D. Brigo (www.damianobrigo.it)

135 / 143

EXERCISES

e.c) There is now a relevant difference between e.a) and e.b). The

reason is that now the two assets offset each other in several

scenarios. When default happens before T1 , the short T1 bond has a

positive value that dominates, in absolute value, the negative bond T2 .

Hence the total NPV in this case is positive but less than if we had only

the first bond. When instead default happens after T1 and before T2 ,

the first bond is gone and we only have the second (negative) bond T2 ,

which being negative gives no contribution to the CVA payout.

Therefore netting benefits us only in scenarios where default is before

T1 . This is confirmed if we compute the difference between CVATOT

and CVANETTING , giving us the price benefit of netting:

CVATOT CVANETTING = CVA1 (CVA1 LGD Q{ < T1 }P(0, T2 )) =

= LGD Q{ < T1 }P(0, T2 ).

(c) 2012-13 D. Brigo (www.damianobrigo.it)

136 / 143

EXERCISES

Risk Measures

Risk Measures I

Consider the dynamics of an equity asset price S in the Black and

Scholes model, under both probability measures P (the Physical or

Historical measure) and Q (the risk neutral measure).

a) Define Value at Risk (VaR) for a time horizon T with confidence

level for a general portfolio.

b) Compute VaR for horizon T and confidence level for a portfolio

with N units of equity, where the equity price follows the Black Scholes

process above.

c) Explain at least one drawback of VaR as a risk measure

d) Is the equity dynamics you used for VaR the same you would have

used to price an equity call option in Black Scholes?

137 / 143

EXERCISES

Risk Measures

Risk Measures II

Solutions.

a)

VaR is related to the potential loss on our portfolio over the time

horizon T . Define this loss LT as the difference between the value of

the portfolio today (time 0) and in the future T .

LT = Portfolio0 PortfolioT .

VaR with horizon T and confidence level is defined as that number

q = qT , such that

P[LT < q] =

so that our loss at time T is smaller than q with P-probability .

In other terms, it is that level of loss over a time T that we will not

exceed with probability . It is the P-percentile of the loss distribution

over T .

(c) 2012-13 D. Brigo (www.damianobrigo.it)

138 / 143

EXERCISES

Risk Measures

b)

In Black Scholes the equity process follows the dynamics

dSt = St dt + St dWt ,

where , are positive constants and W is a brownian motion under

the physical measure P.

We know that ST can be written as

1 2

(1)

ST = S0 exp

T + WT ,

2

and recalling the distribution of WT ,

1 2

ST = S0 exp

T + T N (0, 1)

2

(c) 2012-13 D. Brigo (www.damianobrigo.it)

(2)

139 / 143

EXERCISES

Risk Measures

Risk Measures IV

so that in our case LT = N(S0 ST ), namely

1 2

LT = NS0 1 exp

T + T N (0, 1)

2

Hence

1 2

q

= P[LT < q] = P

1 exp

T + T N (0, 1)

<

2

NS0

1 2

q

=P

T + T N (0, 1) > ln 1

2

NS0

q

1 2

ln 1 NS

T

2

0

=

= P N (0, 1) >

T

(c) 2012-13 D. Brigo (www.damianobrigo.it)

140 / 143

EXERCISES

Risk Measures

Risk Measures V

ln 1

q

NS0

ln 1

q

NS0

12 2 T

= 1

T

q

ln 1 NS

12 2 T

0

=

T

So we have obtained

=

or

1 () =

(c) 2012-13 D. Brigo (www.damianobrigo.it)

ln 1

12 2 T

q

NS0

12 2 T

141 / 143

EXERCISES

Risk Measures

Risk Measures VI

and therefore

1 2

q

1

exp T () + T = 1

2

NS0

1 2

1

q = NS0 1 exp T () + T

2

c) VaR is not subadditive, hence it does not recognize the benefit of

diversification. Also, VaR ignores the structure of the loss distribution

after the percentile. So if 99% VaR is 10 billions, we can have the

remaining 1% loss concentrated

(i) either on 10.1 billions,

(ii) or on 10 trillions,

(c) 2012-13 D. Brigo (www.damianobrigo.it)

142 / 143

EXERCISES

Risk Measures

whether we are in case (i) or (ii).

d) No the dynamics is not the same, to price an option we need to use

the risk neutral dynamics, where the drift parameter of S is replaced

by the risk free rate r of the bank account.

143 / 143

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