Manufacturing and Managing Customer–Driven Derivatives

Praise for

Manufacturing and Managing Customer–Driven Derivatives

"Like many people on the quantitative side of finance I′ve often wondered why and how the more complex derivatives are created. I mean, some of the term sheets I′ve seen are just downright bizarre. Well, thanks to Dong Qu, the expert in both quant finance and the business side, now I know. Dong covers everything from creative ideas, country specifics, regulatory issues, and tax implications, to modeling and risk management. This is an excellent book, unique for its breadth of coverage, genuinely for the whole business of quantitative finance."
Paul Wilmott, Wilmott Magazine

"With so many books out there on derivatives pricing, I thought it was impossible to write a new, original one. Dong Qu proved I was wrong. Not only does this volume focus on the main industry–standard pricing models, it also sheds light on the typical workflow and development process of derivatives contracts in banks, from quant library design to meeting new regulatory risk–management requirements. I wish this book was out there when I started my career as a front–office quant!"
Fabio Mercurio, Global Head of Quant Analytics, Bloomberg

"Everything you always wanted to know about financial derivatives but were afraid to ask could also be the title of this book. Written by an author with over 20 years of experience in the industry, this book joins practical hedging, risk management and regulation issues with sophisticated yet not overly complicated maths. An absolute must for all practitioners and very informative for academicians."
Dariusz Gatarek, Professor, Polish Academy of Sciences

"This book has been expertly written from a practitioner′s viewpoint. Dong Qu uses his vast experience of working in major global banks to create an operationally relevant textbook, delivering a range and subject matter which is very readable and applicable in today′s financial markets. He writes clearly and authoritatively on all aspects of the life–cycle, manufacturing and regulation of structured products. He also uses his mathematical skills to explore and clearly explain pricing models, whilst never ignoring the practicalities of applying quantitative models to actual risk management requirements."
Andrew Law, Global Head of Institutional Sales & Structuring, Bank of Ireland Global Markets

Preface xiii

Acknowledgments xv

About the Author xvii

PART I Overview of Customer–driven Derivative Business 1

CHAPTER 1 Evolving Derivative Business Environment 3

Customer–driven Derivative Product Categories 3

Lessons in Derivatives and Crises 4

Regulations Affecting Derivative Business 7

Structured Derivative Products Geographic Features 11

CHAPTER 2 Pillars in Structured Derivative Business 21

Derivative Business Value Chain 21

Model and Product Development Process 22

Product Issuance and Wrappers 31

Product Distribution 35

CHAPTER 3 Financial Risk Management, Basel III and Beyond 39

Risk Measures and Financial Rule Books 39

Basel III Technical Requirements 41

Internal Model Method (IMM) 48

Beyond Basel III 55

PART II Equity Derivatives 59

CHAPTER 4 Equity Derivatives Market Features 61

Equity Index Underlyings 61

Discrete Dividends 61

Option Settlement Delay 68

Quanto Effect 70

Future Versus Forward 72

Implied Volatility Surface 74

CHAPTER 5 Black Scholes Paradigm 87

Basic Modelling Framework 87

Asian Options 93

Basket Options 100

Dividend Futures and Options 103

American Options 106

Barrier Options 110

Lookback and Hindsight Options 113

Volatility Smile/Skew Dynamics Impact on Hedging 117

CHAPTER 6 Local Volatility Framework 123

Local Volatility Stripper 123

Local Volatility PDE Solver 127

Local Volatility Monte Carlo 132

Local Volatility to Implied Volatility 138

Practical Issues With Local Volatility 142

CHAPTER 7 Stochastic Local Volatility Framework 145

Stochastic Volatility Models 145

SLV Model Formulation 147

SLV Numerical Implementation 150

SLV Numerical Results 154

SLV in Practice 161

CHAPTER 8 Equity–Linked Structured Products 163

General Payoff Category 163

Features of Important Structured Product Categories 168

Barrier Reverse Convertibles 183

Constant Proportion Portfolio Insurance (CPPI) 187

Risks During Retail Issuance Period 193

CHAPTER 9 Basket Option Analysis 197

Basket Option Risks 197

Copula Pricing Models 198

Historic Basket Volatility Surfaces 213

Implied Basket Volatility Surfaces 217

Copula Applications 224

PART III Interest Rate Derivatives 227

CHAPTER 10 Multi–Curve Environment and Yield Curve Stripping 229

Multi–Curve Environment 229

Yield Curve Stripping 237

Collateral Impacts 248

Multi–Curve Multi–Facet Reality 252

CHAPTER 11 Vanilla Interest Rate Options 255

Martingale Pricing Principle 255

Cap/Floor 258

European Swaption and SABR 274

Risk Sensitivities 286

CHAPTER 12 Practical Interest Rate Derivative Models 293

Key Model Categories 293

Linear Gauss Markov Model 295

Libor Market Model 303

Extended Cheyette Model 312

Local Volatility Model 318

CHAPTER 13 CMS Replication and CMS Spread Options 343

CMS Convexity 343

CMS Replication 344

CMS Calibration 350

CMS Spread Option Pricing Framework 356

Copula Pricing with Full Market Marginal Distributions 362

CHAPTER 14 Interest Rate Derivative Products 375

Product Design and Product Risks 375

Bermudan Swaption 381

Callable Products 387

Other Important Products 392

PART IV Real–Life Options and Derivatives 399

CHAPTER 15 Long–dated FX Volatility and Hybrid Risks 401

FX Volatility Surface 401

Extrapolating FX Volatility Term Structure to Long End 403

Extrapolating FX Volatility Smile to Long End 407

Hybrid Optionality 410

PRDC Hybrid Risks 413

CHAPTER 16 Portfolio CVA: Efficient Numerical Techniques 419

CVA Valuation Implementation Framework 420

Numerical Techniques in Portfolio CVA Valuation 420

Grid Monte Carlo for CVA 422

GMC Implementation Example 425

GMC in Practice 432

CHAPTER 17 Contingent Convertibles (CoCo) 435

CoCo Features 435

CoCo Categories 436

CoCo Risk Factors 438

Indirect Modelling Approaches 439

Direct Modelling Approaches 442

CHAPTER 18 Variable Annuity Products 451

Key VA Product Types 453

Major Risk Factors in VA Products 456

Hybrid Pricing Models for VA Products 458

Practicalities of Handling Long–dated VA Products 466

Importance of Understanding VA Risks 469

CHAPTER 19 Interest Rate Optionality in Fixed–Rate Mortgage 473

Prepayment Optionality 473

Prepayment Risk Characteristics 479

Early Redemption Charge 486

Applying Option–Based Prepayment Technique 488

CHAPTER 20 Real Estate Derivatives 491

Equity Release Scheme and Related Derivatives 491

Mortality in Derivatives Pricing 492

Reversion Derivatives Products 497

Real Estate Portfolio Derivatives 501

Property–Linked Roll–Up Mortgage 507

HPI Retail Products 512

APPENDIX A: PRODUCT OF TWO CALLS 515

Decomposition 515

Three Key Integrals 516

Analytical Formula 518

BIBLIOGRAPHY 521

INDEX 531

DONG QU is the global head of the Quantitative Product Group at UniCredit, having previously worked at banks including HSBC, Nikko and Abbey/Santander. He is credited with being instrumental in industrialising barrier reverse convertibles. The barrier protection feature has since become a market stalwart as an industry– standard risk–reduction tool. During his career, He has worked in derivative pricing and hedging models, associated trading and risk management infrastructures, and gained first–hand experience and in–depth knowledge of customer–driven derivatives across major asset classes, including equity, interest rate, FX, credit and real estate.