GARP 2016-FRR - Financial Risk and Regulation (FRR) Series

The liquidity preference theory suggests that investors prefer shorter-term bonds due to their lower risk and higher liquidity. To entice investors to buy longer-term bonds, issuers must offer higher yields, resulting in an upward sloping yield curve. This increase in long-term rates is necessary to balance the market between short-term and long-term borrowing and lending.

Vega represents the sensitivity of an option's price to changes in the volatility of the underlying asset. If a call option on the GBP has a Vega of 0.02, this means that for every 1% increase in the perceived future volatility, the price of the call option will increase by 0.02. Therefore, if the volatility increases by 1%, the call option's value increases by 0.02.

Corporate customers use foreign exchange derivatives for several reasons:

To lock in the current value of foreign-denominated receivables (I)

To lock in the current value of foreign-denominated payables (II)

To lock in the value of expected future foreign-denominated receivables (III)

To lock in the value of expected future foreign-denominated payables (IV) These derivatives are used as a hedging mechanism to manage currency risk and provide certainty regarding future cash flows and costs.

Herd behavior in the context of credit defaults refers to a situation where the stigma of default decreases, leading more borrowers to default as they see others doing the same. This creates a pattern of increasing defaults in the neighborhood as more borrowers follow the trend.

Beta Bank can directly sell bonds and marketable loans in the secondary market. These instruments are typically more liquid and can be traded between financial institutions.

Credit card loans, on the other hand, are usually not directly sold as they are more personalized and less standardized compared to bonds and marketable loans.

The value of foreign exchange options is influenced by several factors, including:

Change in the value of the underlying (I):This directly affects the option's intrinsic value.

Change in the perception of future volatility (II):Higher expected volatility increases the option's potential payoff.

Change in interest rates (III):This affects the cost of carrying positions in the underlying asset.

Passage of time (IV):This influences the time value of the option. All these factors collectively impact the pricing dynamics of options throughout the trading day.

Compound options are exotic options that have another option as their underlying asset, making them particularly complex to model. The complexity arises because the value of a compound option is derived from another option, which is already a derivative with its own set of valuation challenges. This nested structure introduces multiple layers of volatility and dependencies that are difficult to predict and model accurately using standard option pricing models.

When trading exotic options, various risks need to be considered. Spot foreign exchange risks (I) involve the risk associated with the current exchange rate fluctuations. Forward foreign exchange risks (II) pertain to the risks related to future exchange rate changes agreed upon in forward contracts. Plain vanilla options risks (III) include the standard risks associated with basicoption trading, such as volatility and time decay. Option-specific risks (IV) refer to the unique risks inherent in the specific exotic option being traded, such as path-dependency, barrier levels, and the complexity of modeling their payoffs. All these risks collectively impact the trading of exotic options.

The pricing of credit default swaps (CDS) is primarily influenced by:

Probability of Default:The likelihood that the underlying entity will default on its obligations.

Duration:The term or maturity of the CDS contract.

Loss Given Default:The expected loss if the underlying entity defaults.

Market spreads, while relevant to bond pricing and other instruments, are not a direct factor in the calculation of the pricing of CDS contracts.

References

Verified information on CDS pricing factors from the document ​

The credit spread reflects the additional yield over the risk-free rate that investors demand to compensate for the risk of default. An increase in the probability of default of the issuer (I) would directly increase the credit spread as investors require more return for higher risk. Similarly, an increase in expected loss (IV) would increase the credit spread since the potential loss in the event of default is greater. On the other hand, a decrease in risk premium (II) or a decrease in loss given default (III) would typically lower the credit spread, not increase it.