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Old 19.05.2011, 22:05
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One for the egg-heads: Interest Rate Derivative Pricing

OK. Instead of being a normal person and getting a fixed rate mortgage, I'm looking at buying Interest Rate Cap Warrants to hedge interest rate risk:

https://quotes-public1.ubs.com/app/C...pg_ubsProducts

Anyone know how to model/price these?

I'm looking to put in a set of probabilities at different points for the interest rates between now and the strike date and from this have a spreadsheet/program spit out the value of the derivative based on these inputs.

EDIT to add:

I'm looking the the model to work in one of two ways: one is to get a held to maturity valuation and the other assuming a liquid market and putting in a 'spread' to enable the derivative to be traded at any time e.g. if you buy a 10 year warrant and the IR spikes at 5 years and falls back to below strike price, under the 2nd model, the warrant will have a value based on the ability to trade at the 5 year spike. Hope that makes sense.

Also happy to accept a book or maths paper on the subject...
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Old 19.05.2011, 22:39
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Re: One for the egg-heads: Interest Rate Derivative Pricing

OK. Apparently it is called a Caplet and you can price it with the Black model.
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Old 19.05.2011, 23:25
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Re: One for the egg-heads: Interest Rate Derivative Pricing

Why not just look at the price of a 10 year cap/warrent in the market?
Compare that with the spread. What use is a theoretical (model) price?

You should be able to price the warrant with a series of smaller caps, and get a more realistic valuation from the market. You could then use your model to value the smaller caps, and see where the theoretical diverges from market prices.

To learn about option trading I bought:

http://www.hoadley.net/options/options.htm

and then entered a few option contracts, hedging the greeks with the above.

Warrants can be a complete rip off. Large spreads, manipulation.
Try and use the more liquid exchange traded options. Say price a bunch of call options. Trying to sell a warrant early is like swapping life insurance policies. i always got shafted when I tried.

One problem is that the risk profile of the cap you build won't match a particular mortgage product exactly.
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Old 20.05.2011, 00:04
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Re: One for the egg-heads: Interest Rate Derivative Pricing

Quote:
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Why not just look at the price of a 10 year cap/warrent in the market?
Compare that with the spread. What use is a theoretical (model) price?

You should be able to price the warrant with a series of smaller caps, and get a more realistic valuation from the market. You could then use your model to value the smaller caps, and see where the theoretical diverges from market prices.

To learn about option trading I bought:

http://www.hoadley.net/options/options.htm

and then entered a few option contracts, hedging the greeks with the above.

Warrants can be a complete rip off. Large spreads, manipulation.
Try and use the more liquid exchange traded options. Say price a bunch of call options. Trying to sell a warrant early is like swapping life insurance policies. i always got shafted when I tried.

One problem is that the risk profile of the cap you build won't match a particular mortgage product exactly.
Seems like a complex way to hedge interest rate movements (in this case, an interest rate increase). The main downside would be the lack of liquidity in the market for the opposite side of this trade.

Much easier would be to take out a number of mortgages, one fixed at a certain rate for a certain number of years, through to one variable at a percentage point above LIBOR.

At present, the chances of Swiss interest rates rising are still very low since the CHF is already too high, and an increase would send its value skywards.
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