Professional Documents
Culture Documents
Stochastic Modeling
Symposium
By
Thomas S.Y. Ho PhD
Thomas Ho Company, Ltd
Tom.ho@thomasho.com
April 3, 2006
Purpose
Overview of the basic principles in the
relative valuation models
Overview of the basic terminologies
Equity derivatives
Fixed income securities
Traditional Valuation
Net present value
Expected cashflows
Cost of capital as opposed to cost of
funding
Capital asset pricing model
Cost of capital of a firm as opposed to cost
of capital of a project (or security)
Relative Valuation
Law of one price: extending to nontradable financial instruments
Applicability to insurance products and
annuities (loans and GICs)
Arbitrage process and relative pricing
C = uCu + dCd
S=
1 = uexp(rT)+ dexp(rT)
uSu + dSd
100
100
Stock Volatility
0.2
Risk-free rate
0.05
dividend yields
N/A
dt = T/n
upward movement
1.0851
= exp(dt)
downward movement
0.9216
= 1/u
risk-neutral probability of u
0.5308
= (exp(rdt)-d)/(u-d)
Stock lattice
163.21
4965
stock lattice
time
150.41
8059
138.62
4497
138.62
4497
127.75
5612
117.738
905
127.75
5612
117.738
905
108.50
756
100
117.738
905
108.50
756
100
92.159
4775
84.933
693
108.50
756
100
92.159
4775
84.933
693
78.274
4477
72.137
3221
100
92.159
4775
84.933
693
78.274
4477
72.137
3221
66.481
3791
61.268
8917
10.125573
51.247930
38.624497
40.277352
28.585483
17.738905
30.224621
19.391759
9.337430
0.000000
21.723634
12.494533
4.915050
0.000000
0.000000
15.055460
7.780762
2.587191
0.000000
0.000000
0.000000
4.729344
1.361849
0.000000
0.000000
0.000000
0.000000
10
1 = pu + pd
1 = qu + qd
11
Ito process
Z = g( t, X)
12
Numeraires and
Probabilities
Z(t) = V(t)/R(t)
dS/S = (r- q) dt + sdB(t)
V as numeraire
Z(t) = R(t)/V(t)
dS/S = (r q + s2)dt + s dB
13
Y as numeraire
Z(t) = V(t)/Y(t)
dS/S = (r q + s y)dt + s dB
Volatility invariant
14
Life products
Fixed annuities
Variable annuities
15
Sensitivity Measures
Delta , S
Gamma ,
Theta (time decay) t
Vega v measure
Rho , r
Relationships of the sensitivity measures
Intuitive explanation of the greeks
100
100
?
Stock volitility ()
0.2
0.04
Dividend yields ()
0
17
Put
Price
9.92505
6.00400
(Delta)
0.61791
-0.38209
(Gamma)
0.01907
0.01907
v (Vega)
38.13878
38.13878
(Theta)
-5.88852
-2.04536
(Rho)
51.86609
-44.21286
18
19
0.060
0.060
0.065
0.070
0.075
0.080
1.00000
0
0.94176
5
0.87809
5
0.81058
4
0.74081
8
0.67032
0
0.060
0.060
0.070
0.080
0.090
0.100
0.0775
0.0775
0.0775
0.0775
0.0775
0.0775
0.0775
0.0775
0.0775
0.0775
20
0.87964
7
0.87469
5
0.89695
1
0.89200
4
0.88835
8
0.91310
5
0.90814
3
0.90453
4
0.90223
5
0.92805
8
0.92306
6
0.91947
4
0.91724
1
0.91632
8
0.94176
5
0.93672
9
0.93313
6
0.93094
6
0.93012
6
0.93064
2
year
21
0.12823
51
0.13388
06
0.10875
38
0.11428
51
0.11838
06
0.09090
47
0.09635
38
0.10033
51
0.10288
06
0.07466
08
0.08005
47
0.08395
38
0.08638
51
0.08738
06
0.06
0.06536
08
0.06920
47
0.07155
38
0.07243
51
0.07188
06
year
22
P( n 1)
P ( n)
Pi n (1)
1 n1 n2 1 1 n1 2
1 n 1 1 n 2 1 n
ni
0.86673
1
0.926800
0.94176
0.88096
3
0.87807
2
0.89598
0
0.89266
8
0.88956
2
0.9
11
39
5
0.90779
5
0.90453
0
0.90120
1
0.9
23
04
4
0.91976
5
0.91654
9
0.91299
4
0.9
34
23
0.93189
0.92872
0.92494
P ( n 1)
1 n 1 n 2 L 1 L 1 n 1 2
P ( n)
1 n L 1 1 n L 2 L 1 n
ni
Pi n (1)
0.1
0.095
0.09
0.085
0.08
0.1
0.0907143
0.081875
0.0733333
0.065
Ho-Lee
model rates
with term
structure of
volatilities
0.1430264
0.1267402
0.1300264
0.1098368
0.1135402
0.1170264
0.0927784
0.0967368
0.1003402
0.1040264
0.076018
0.0800784
0.0836368
0.0871402
0.0910264
0.06
0.064018
0.0673784
0.0705368
0.0739402
0.0780264
24
Alternative Arbitrage-free
Interest Rate Modeling
25
Alternative Valuation
Algorithms
monte-carlo
Antithetic, control variate
Structured sampling
26
27
Examples of Applications
Mortgage-backed securities
Prepayment models
CMOs
28
Conclusions
Comparing relative valuation and the NPV
model
Imagine the world without relative
valuation
Beyond the Primer:
29
References
Ho and Lee (2005) The Oxford Guide to
Financial Modeling Oxford University Press
Excel models (185 models)
www.thomasho.com
Email: tom.ho@thomasho.com
30