Risk Analysis of Multi Asset Options

Link

For the fence sitters

Link

PRDC’s – The game of Long dated FX

Cross-Gamma risks and how it impacts the volatility and interest rate markets?

Here we discuss the risks for the USDJPY pair.

Structure is a strip of ITM and OTM (because of forward trading at discount) calls, with issuer having an option to call back the note at every coupon date. The issuer callability feature is synonymous to a knock out feature, since the issuer calls back the note when coupons paid exceed the (Libor received + the value of callability option). So in essence it resembles a KO call type payoff and exhibits similar risks (especially vega)

FX Vega

Seller is short skew because of the callable feature.

The expected maturity of the product changes with changes in volatility, spot and basis (JPY – USD interest rate). An increase in spot, volatility or basis will reduce the tenure since the Moneyness of the option and subsequently chances of issuer calling it back increases.

As spot increases, trader gets longer short term vega. As spot decreases trader gets short long term vega. Later can be a problem because of two reasons

• Long term vega is illiquid
  
• When spot decreases, there is dearth of vega sellers (Everyone rushes to buy protection)
  

Long term smile is determined by supply demand which might not respond to the dynamics of the FX spot. This poses significant problems in modeling it.

Cross Gamma FX, Interest rate

Issuer is receiving a stream of JPY Libor. An increase in spot decreases the expected maturity and hence traders needs to buyback the long term libor and sell the short term ones. Given the size of the PRDC market, this causes curve steepening and vice-versa when spot decreases.

Clearly the trader is short FX spot, JPY basis (Long term rate – Short term rate) correlation.

Long dated options – Volatility of the forward

When pricing long dated options, one needs to take into account the volatility of the forward which in turn depends on

• Volatility of the spot
  
• and correlation between the spot and the basis (JPY – USD) * Recall the basic no arbitrage equation relating forward with spot and interest rates.
  

Clearly an increase in correlation will increase the volatility of the forward and hence increase the price of those long term OTM calls.

Exotic Option Strategies for the current market

Link to the article

Worst of up and out put – Vega Risk and Correlation skew

Link to the article.

In case of any questions contact: exotics.trader@gmail.com