Francesco Chiminello Barclays Capital This presentation has been prepared by Barclays Capital - the investment banking division of Barclays Bank PLC and its affiliates worldwide (Barclays Capital). This publication is provided to you for information purposes, any pricing in this report is indicative and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The information contained herein has been obtained from sources believed to be reliable but Barclays Capital does not represent or warrant that it is accurate and complete. The views reflected herein are those of Barclays Capital and are subject to change without notice. Barclays Capital and its respective officers, directors, partners and employees, including persons involved in the preparation or issuance of this document, may from time to time act as manager, co-manager or underwriter of a public offering or otherwise deal in, hold or act as market-makers or advisors, brokers or commercial and/or investment bankers in relation to the securities or related derivatives which are the subject of this report. Neither Barclays Capital, nor any officer or employee thereof accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents. Any securities recommendations made herein may not be suitable for all investors. Past performance is no guarantee of future returns. Any modelling or back-testing data contained in this document is not intended to be a statement as to future performance. Investors should seek their own advice as to the suitability of any investments described herein for their own financial or tax circumstances. This communication is being made available in the UK and Europe to persons who are investment professionals as that term is defined in Article 19 of the Financial Services and Markets Act 2000 (Financial Promotion Order) 2001. It is directed at persons who have professional experience in matters relating to investments. The investments to which is relates are available only to such persons and will be entered into only with such persons. Barclays Capital - the investment banking division of Barclays Bank PLC, authorized and regulated by the Financial Services Authority (FSA) and member of the London Stock Exchange. Copyright in this report is owned by Barclays Capital ( Barclays Bank PLC, 2005) - no part of this report may be reproduced in any manner without the prior written permission of Barclays Capital. Barclays Bank PLC is registered in England No. 1026167. Registered office 1 Churchill Place, London E14 5HP.
Risks by MC: re-simulation Re-simulation approach take a mkt parameter q bump it by an amount dq re-run the simulation risks by finite differences: P X (q+dq) P X (q-dq)
Pros: simple to implement unbiased by construction consistent with PL by construction
Cons: computational requirements MC noise Risks by MC: re-simulation MC noise in risks amplified by taking small differences larger bumps than in analytic/PDE prices
reduced by the high correlation between simulations reuse of same random numbers theta can problematic affected by local vol surface
compute risks by finite differences
bootstrap/term structure noise Risks by MC: other approaches Pathwise derivatives derivation on option-by-option basis no discontinuous payouts difficult to compute transition probabilities
Likelihood ratio works well with single-step MC works very badly for daily steps MC
Benchmark instruments similar to weighted MC need a complete base of benchmarks a lot of benchmarks to be chosen and computed incomplete basis will give nonsensical results Risks by MC In the following, it is assumed that computation by re-simulation is the only practically available methodology for risks.
How can the adverse effects of MC noise be mitigated, under the constraint of finite computational power?
Note that by the sqrt(N) law, even modest improvements can be significant. Example TARN An Energy TARN will be used for the numerical examples.
Rationale of the choice:
complex path-dependent trade justifies use of MC realistic commodities trade payout is defined in terms of Asian averages underlying is a complex portfolio of options digital component to the payout not Longstaff-Schwartz
Example trade: TARN Monthly payments, 1 year duration first payment is evaldate+2months
Underlying portfolio of options is a 3-way: short 2 puts at 65 $/bbl long 1 call at 90 $/bbl short 1 call at 105 $/bbl observing the prompt contract at all times
Early termination if cumulative sum of call spreads reaches 40$, deal terminates maximum total positive payout is 40$ adjustment to last coupon in case of early termination Example trade: market, model, simulation simplified forward curve: all forwards 85 $/bbl
realistic implied volatilities from the market ATM ranging from 42% down to 32% Skews ranging from -2% to 7%
2-factors model with term structure of volatility
all simulations are run with 10000 antithetic paths interested in MC noise
Obvious approach: soft cap similar to digital options as call spreads choose a range around cap level fractionally exercise within the range need to guess correlation of consecutive hits: multiplication (not realistic) minimum (not smooth) Does not seem to work well Scattered TARN How to handle the noise from TARNs cumulative cap?
Other approach: scattered TARN choose a range around cap level this example: 8.92 $ choose a number of evenly-spread levels price a portfolio of TARNs, one for each level average out the result
No need to guess correlation Works quite well
Scattered TARN Refinements:
Use the above approach to decide if any of the scattered TARNs knocks out, but compute the KO payout according to the original cap level (smaller bias)
No need to actually price all TARNs literally, just need to keep a counter of the highest breached cap level