Economics and Finance

1906 Submissions

[5] viXra:1906.0571 [pdf] submitted on 2019-06-30 16:51:25

Is the Jump-Diffusion Model a Good Solution for Credit Risk Modeling? The Case of Convertible Bonds

Authors: Tim Xiao
Comments: 36 Pages. International Journal of Financial Markets and Derivatives, 4(1) 1-25, 2015

This paper argues that the reduced-form jump diffusion model may not be appropriate for credit risk modeling. To correctly value hybrid defaultable financial instruments, e.g., convertible bonds, we present a new framework that relies on the probability distribution of a default jump rather than the default jump itself, as the default jump is usually inaccessible. As such, the model can back out the market prices of convertible bonds. A prevailing belief in the market is that convertible arbitrage is mainly due to convertible underpricing. Empirically, however, we do not find evidence supporting the underpricing hypothesis. Instead, we find that convertibles have relatively large positive gammas. As a typical convertible arbitrage strategy employs delta-neutral hedging, a large positive gamma can make the portfolio highly profitable, especially for a large movement in the underlying stock price.
Category: Economics and Finance

[4] viXra:1906.0481 [pdf] submitted on 2019-06-25 17:04:37

An Efficient Lattice Algorithm for the Libor Market Model

Authors: Tim Xiao
Comments: 32 Pages. Journal of Derivatives, 19 (1), 25-40, 2011

The LIBOR Market Model has become one of the most popular models for pricing interest rate products. It is commonly believed that Monte-Carlo simulation is the only viable method available for the LIBOR Market Model. In this article, however, we propose a lattice approach to price interest rate products within the LIBOR Market Model by introducing a shifted forward measure and several novel fast drift approximation methods. This model should achieve the best performance without losing much accuracy. Moreover, the calibration is almost automatic and it is simple and easy to implement. Adding this model to the valuation toolkit is actually quite useful; especially for risk management or in the case there is a need for a quick turnaround.
Category: Economics and Finance

[3] viXra:1906.0338 [pdf] submitted on 2019-06-18 18:12:46

A Simple and Precise Method for Pricing Convertible Bond with Credit Risk

Authors: Tim Xiao
Comments: 30 Pages.

This paper presents a new model for valuing hybrid defaultable financial instruments, such as, convertible bonds. In contrast to previous studies, the model relies on the probability distribution of a default jump rather than the default jump itself, as the default jump is usually inaccessible. As such, the model can back out the market prices of convertible bonds. A prevailing belief in the market is that convertible arbitrage is mainly due to convertible underpricing. Empirically, however, we do not find evidence supporting the underpricing hypothesis. Instead, we find that convertibles have relatively large positive gammas. As a typical convertible arbitrage strategy employs delta-neutral hedging, a large positive gamma can make the portfolio highly profitable, especially for a large movement in the underlying stock price.
Category: Economics and Finance

[2] viXra:1906.0188 [pdf] submitted on 2019-06-11 18:20:16

An Accurate Solution for Credit Valuation Adjustment (CVA) and Wrong Way Risk

Authors: Tim Xiao
Comments: 25 Pages. Journal of Fixed Income, 25 (1) 84-95, 2015

This paper presents a Least Square Monte Carlo approach for accurately calculating credit value adjustment (CVA). In contrast to previous studies, the model relies on the probability distribution of a default time/jump rather than the default time itself, as the default time is usually inaccessible. As such, the model can achieve a high order of accuracy with a relatively easy implementation. We find that the valuation of a defaultable derivative is normally determined via backward induction when their payoffs could be positive or negative. Moreover, the model can naturally capture wrong or right way risk.
Category: Economics and Finance

[1] viXra:1906.0157 [pdf] submitted on 2019-06-09 11:19:44

A New Model for Pricing Collateralized OTC Derivatives

Authors: Tim Xiao
Comments: 26 Pages. Journal of Derivatives

This paper presents a new model for pricing OTC derivatives subject to collateralization. It allows for collateral posting adhering to bankruptcy laws. As such, the model can back out the market price of a collateralized contract. This framework is very useful for valuing outstanding derivatives. Using a unique dataset, we find empirical evidence that credit risk alone is not overly important in determining credit-related spreads. Only accounting for both collateral arrangement and credit risk can sufficiently explain unsecured credit costs. This finding suggests that failure to properly account for collateralization may result in significant mispricing of derivatives. We also empirically gauge the impact of collateral agreements on risk measurements. Our findings indicate that there are important interactions between market and credit risk.
Category: Economics and Finance