Rethinking Valuation and Pricing Models

Rethinking Valuation and Pricing Models

Lessons Learned from the Crisis and Future Challenges

1st Edition - November 8, 2012

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  • Editors: Carsten Wehn, Christian Hoppe, Greg Gregoriou
  • Hardcover ISBN: 9780124158757
  • eBook ISBN: 9780124158887

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It is widely acknowledged that many financial modelling techniques failed during the financial crisis, and in our post-crisis environment many techniques are being reconsidered.  This single volume provides a guide to lessons learned for practitioners and a reference for academics.  Including reviews of traditional approaches, real examples, and case studies, contributors consider portfolio theory; methods for valuing equities and equity derivatives, interest rate derivatives, and hybrid products; and techniques for calculating risks and implementing investment strategies.  Describing new approaches without losing sight of their classical antecedents, this collection of original articles presents a timely perspective on our post-crisis paradigm.

Key Features

  • Highlights pre-crisis best classical practices, identifies post-crisis key issues, and examines emerging approaches to solving those issues
  • Singles out key factors one must consider when valuing or calculating risks in the post-crisis environment
  • Presents material in a homogenous, practical, clear, and not overly technical manner


Addresses issues relevant for upper-division undergraduates, graduate students, and professionals worldwide working in asset management / trading / risk control of banks and insurance companies / consultancy firms  / auditing / regulation / applied mathematics and finance

Table of Contents

  • Editor’s Disclaimers




    1. The Effectiveness of Option Pricing Models During Financial Crises

    1.1 Introduction

    1.2 Methodology

    1.3 Data

    1.4 Results

    1.5 Concluding Remarks


    2. Taking Collateral into Account

    2.1 Introduction

    2.2 Notations and Problem

    2.3 Black–Scholes Partial Differential Equation in the Presence of Collateral

    2.4 Collateral Discount Curve Bootstrapping

    2.5 Pricing and Bootstrapping of the IR Vanilla Swap Term Structure

    2.6 European Swaption Pricing Framework

    2.7 Collateral Effect and Term-Structure Models

    2.8 Conclusion


    3. Scenario Analysis in Charge of Model Selection

    3.1 Introduction to Model Risk

    3.2 Classical Calibration Procedure

    3.3 Processes, Dynamics and Model Definition

    3.4 Importance of Risk Premia

    3.5 Equity Volatility Modeling

    3.6 Foreign Exchange Volatility Modeling

    3.7 Conclusions



    4. An “Economical” Pricing Model for Hybrid Products

    4.1 Introduction

    4.2 Pricing Convertible Bonds

    4.3 Two-Factor Numerical Procedure

    4.4 Default Risk

    4.5 Pricing Convertible Bonds Subject to Interest Rate Risk and Default Risk

    4.6 Conclusion



    5. Credit Valuation Adjustments– Mathematical Foundations, Practical Implementation and Wrong Way Risks

    5.1 Introduction

    5.2 Mathematical Foundations of CVA

    5.3 Practical Implementation: Issues and (Wrong Way) Risks

    5.4 Model Risks in CVA Calculation

    5.5 Summary and Prospects



    6. Counterparty Credit Risk and Credit Valuation Adjustments (CVAs) for Interest Rate Derivatives–Current Challenges for CVA Desks

    6.1 Introduction

    6.2 Traditional Counterparty Risk Management Approaches

    6.3 Modeling Credit Exposure and Pricing CCR

    6.4 New Challenges and Reactions

    6.5 Practical Problems

    6.6 Conclusions and Lessons Learned


    7. Designing a Counterparty Risk Management Infrastructure for Derivatives

    7.1 Need for an Integrated Counterparty Risk Management

    7.2 Building Blocks for an Adequate Infrastructure

    7.3 General Computing Approach

    7.4 Trade Assessment



    8. A Jump–Diffusion Nominal Short Rate Model

    8.1 Introduction

    8.2 The Economy

    8.3 Equilibrium Interest Rates and Monetary Policy

    8.4 A Nominal Interest Rate Model

    8.5 Conclusion

    Appendix: Proof of Proposition 2



    9. The Widening of the Basis: New Market Formulas for Swaps, Caps and Swaptions

    9.1 Introduction

    9.2 Assumptions on the Discount Curve

    9.3 Fra Rates: Definition and Pricing

    9.4 IRS Valuation

    9.5 Pricing of Caplets and Swaptions

    9.6 Conclusions


    10. The Financial Crisis and the Credit Derivatives Pricing Models

    10.1 Introduction

    10.2 Brief Description of Credit Derivatives

    10.3 CDO Pricing Models and the Financial Crisis

    10.4 Conclusion: Risk Premia and Asset Pricing Models


    11. Industry Valuation-Driven Earnings Management

    11.1 Introduction

    11.2 Literature Review and Hypotheses Development

    11.3 Data and Variables

    11.4 Empirical Tests and Results

    11.5 Conclusion


    12. Valuation of Young Growth Firms and Firms in Emerging Economies

    12.1 Introduction

    12.2 The Basic Problem

    12.3 Data and Numerical Procedure

    12.4 Results

    12.5 Conclusion


    13. Towards a Replicating Market Model for the US Oil and Gas Sector

    13.1 Introduction

    13.2 Model

    13.3 Data

    13.4 Preliminary Analysis and Results

    13.5 Main Results

    13.6 Conclusion


    14. Measuring Systemic Risk from Country Fundamentals: A Data Mining Approach

    14.1 Introduction

    14.2 Financial Crises and Leading Indicators

    14.3 Financial Crises and Risk Signals

    14.4 Analysis and Results

    14.5 Conclusions


    15. Computing Reliable Default Probabilities in Turbulent Times

    15.1 Introduction

    15.2 Brief Review of the KMV-Merton Model

    15.3 Brief Review of the ZPP Model

    15.4 Empirical Analysis

    15.5 Conclusion


    16. Discount Rates, Default Risk and Asset Pricing in a Regime Change Model

    16.1 Introduction

    16.2 Proxy for Discount Rates from a Regime Change Model

    16.3 Leveraging, Risk Premia and Asset Prices using Brownian Motions

    16.4 Discount Rates, Risk Premia and Asset Prices in a Dynamic Model

    16.5 Results of the Numerical Study

    16.6 Conclusions


    17. A Review of Market Risk Measures and Computation Techniques

    17.1 Introduction

    17.2 Market Risk, Portfolio Value and Returns

    17.3 Market Risk Factors and Portfolio Value

    17.4 Major Market Risk Measures and Their Computation Methods

    17.5 Backtesting of Market Risk Computation Methods

    17.6 Conclusion

    Appendix: Stochastic Processes Used in Finance


    18. High-Frequency Performance of Value at Risk and Expected Shortfall: Evidence from ISE30 Index Futures

    18.1 Introduction

    18.2 Literature

    18.3 Market and Data

    18.4 Methodology

    18.5 Empirical Results

    18.6 Conclusion



    19. A Copula Approach to Dependence Structure in Petroleum Markets

    19.1 Introduction

    19.2 Empirical Methodology

    19.3 Data and Results

    19.4 Conclusion


    20. Mistakes in the Market Approach to Correlation: A Lesson For Future Stress-Testing

    20.1 Introduction

    20.2 From Flat Correlation towards a Realistic Approach

    20.3 Payoff Stress and the Liquidity Mistake

    20.4 Testing with Historical Scenarios and the Concentration Mistake

    20.5 Lessons for Future Stress-Testing



    21. On Correlations between a Contract and Portfolio and Internal Capital Alliocation

    21.1 Introduction

    21.2 Adding a Deal to a Company Portfolio

    21.3 Example: Correlated Power-Law Distributions

    21.4 Formula for the Quantile Shift

    21.5 Quantile Shift Under Secondary Uncertainty

    21.6 Capital Allocation by Average Shortfall

    21.7 Evolution of Quantiles in Portfolio Aggregation

    21.8 Static and Dynamic Capital Allocation

    21.9 Conclusion


    22. A Maximum Entropy Approach to the Measurement of Event Risk

    22.1 Introduction

    22.2 Theory and Methods

    22.3 Empirical Analysis

    22.4 Conclusions


    23. Quantifying the Unquantifiable: Risks Not in Value at Risk

    23.1 Introduction and Motivation

    23.2 Regulatory Developments and Requirements

    23.3 Examples of Different Products and Risk Factors

    23.4 Approaches to Quantifying Risks not in VaR

    23.5 Treatment within the Internal Capital Adequacy Process

    23.6 Conclusion and Outlook



    24. Active Portfolio Construction When Risk and Alpha Factors are Misaligned

    24.1 Introduction

    24.2 Framework for Active Portfolio Construction

    24.3 Misalignment of Risk and Alpha Models

    24.4 Portfolio Optimization with Alpha Decomposition

    24.5 Mitigation for Alpha and Risk Factor Misalignment

    24.6 Case Studies

    24.7 Conclusion


    25. Market Volatility, Optimal Portfolios and Naive Asset Allocations

    25.1 Introduction

    25.2 Mean and Variance Forecasts

    25.3 Investment Sets

    25.4 Performance Evaluation

    25.5 Results from the Full Sample-Analysis

    25.6 Rolling Performance Evaluation and Market Volatility

    25.7 Conclusions


    26. Hedging Strategies with Variable Purchase Options

    26.1 Introduction

    26.2 Description of the Product

    26.3 Pricing and Hedging Bounded VPOs

    26.4 Conclusions



    27. Asset Selection Using a Factor Model and Data Envelopment Analysis– A Quantile Regression Approach

    27.1 Introduction

    27.3 Data and Methodology

    27.4 Discussion of Results

    27.5 Conclusion


    28. Tail Risk Reduction Strategies

    28.1 Introduction

    28.2 Data and Methodology

    28.3 Empirical Results

    28.4 Conclusion


    29. Identification and Valuation Implications of Financial Market Spirals

    29.1 Introduction

    29.2 Literature Review

    29.3 Data and Descriptive Statistics

    29.4 Results

    29.5 Conclusion


    30. A Rating-Based Approach to Pricing Sovereign Credit Risk

    30.1 Introduction

    30.2 Literature Review and Methodology

    30.3 Dataset

    30.4 Transition Matrices Estimation

    30.5 Asset Pricing

    30.6 Conclusions



    31. Optimal Portfolio Choice, Derivatives and Event Risk

    31.1 Introduction

    31.2 Model

    31.3 Parameter Estimation

    31.4 Optimal Portfolios

    31.5 Conclusion


    32. Valuation and Pricing Concepts in Accounting and Banking Regulation

    32.1 Introduction

    32.2 Accounting

    32.3 Banking Regulation

    32.4 Critical Assessment

    32.5 Conclusion


    33. Regulation, Regulatory Uncertainty and the Stock Market: The Case of Short Sale Bans

    33.1 Introduction

    33.2 Classical Models: Theoretical Models of Constraining Short Sales

    33.3 Empirical Evidence Prior to the 2008 Financial Crisis

    33.4 Empirical Evidence from and Since the Financial Crisis of 2008

    33.5 Future Challenges


    34. Quantitative Easing, Financial Risk and Portfolio Diversification

    34.1 Introduction

    34.2 Financial Markets and Macro-Finance Indicators Before and After 2006

    34.3 Risk Aversion, Risk Premia and the Discounting Process

    34.4 Concluding Remarks


    35. Revisiting Interest Rate Pricing Models from an Indian Perspective: Lessons and Challenges

    35.1 Introduction

    35.2 Success and Lessons

    35.3 Challenges

    35.4 Conclusion


    36. Investment Opportunities in Australia’s Healthcare Stock Markets After the Recent Global Financial Crisis

    36.1 Introduction

    36.2 Patterned Vecm Modeling and Causality Measurement

    36.3 Data and Empirical Vecm Findings

    36.4 Conclusion


    37. Predicting ASX Health Care Stock Index Movements After the Recent Financial Crisis Using Patterned Neural Networks

    37.1 Introduction

    37.2 Construction of a Polynomial Neural Networks Using a Patterned VAR

    37.3 Data and Empirical Sparse-Patterned VAR Findings

    37.4 Conclusion



Product details

  • No. of pages: 652
  • Language: English
  • Copyright: © Academic Press 2012
  • Published: November 8, 2012
  • Imprint: Academic Press
  • Hardcover ISBN: 9780124158757
  • eBook ISBN: 9780124158887

About the Editors

Carsten Wehn

Head of the risk modelling team at DekaBank, Frankfurt, Germany. He is responsible for development and validation of internal portfolio models for measuring and managing credit risk.

Affiliations and Expertise

DeKaBank, Frankfurt, Germany

Christian Hoppe

Christian Hoppe is the Head of Credit Solutions at Commerzbank, Frankfurt, Germany, and the founder of Anleihen Finder GmbH.

Affiliations and Expertise

Commerzbank, Frankfurt, Germany

Greg Gregoriou

Greg Gregoriou

A native of Montreal, Professor Greg N. Gregoriou obtained his joint Ph.D. in finance at the University of Quebec at Montreal which merges the resources of Montreal's four major universities McGill, Concordia, UQAM and HEC. Professor Gregoriou is Professor of Finance at State University of New York (Plattsburgh) and has taught a variety of finance courses such as Alternative Investments, International Finance, Money and Capital Markets, Portfolio Management, and Corporate Finance. He has also lectured at the University of Vermont, Universidad de Navarra and at the University of Quebec at Montreal.

Professor Gregoriou has published 50 books, 65 refereed publications in peer-reviewed journals and 24 book chapters since his arrival at SUNY Plattsburgh in August 2003. Professor Gregoriou's books have been published by McGraw-Hill, John Wiley & Sons, Elsevier-Butterworth/Heinemann, Taylor and Francis/CRC Press, Palgrave-MacMillan and Risk Books. Four of his books have been translated into Chinese and Russian. His academic articles have appeared in well-known peer-reviewed journals such as the Review of Asset Pricing Studies, Journal of Portfolio Management, Journal of Futures Markets, European Journal of Operational Research, Annals of Operations Research, Computers and Operations Research, etc.

Professor Gregoriou is the derivatives editor and editorial board member for the Journal of Asset Management as well as editorial board member for the Journal of Wealth Management, the Journal of Risk Management in Financial Institutions, Market Integrity, IEB International Journal of Finance, and the Brazilian Business Review. Professor Gregoriou's interests focus on hedge funds, funds of funds, commodity trading advisors, managed futures, venture capital and private equity. He has also been quoted several times in the New York Times, Barron's, the Financial Times of London, Le Temps (Geneva), Les Echos (Paris) and L'Observateur de Monaco. He has done consulting work for numerous clients and investment firms in Montreal. He is a part-time lecturer in finance at McGill University, an advisory member of the Markets and Services Research Centre at Edith Cowan University in Joondalup (Australia), a senior advisor to the Ferrell Asset Management Group in Singapore and a research associate with the University of Quebec at Montreal's CDP Capital Chair in Portfolio Management. He is on the advisory board of the Research Center for Operations and Productivity Management at the University of Science and Technology (Management School) in Hefei, Anhui, China.

Affiliations and Expertise

School of Business and Economics, State University of New York, Plattsburgh, NY, USA

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