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MRMM-3-the-science-of-term-structure-models.html
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<!doctype html>
<html lang="en">
<head>
<meta charset="utf-8">
<title>Market Risk Measurement and Management | Chapter 3 | The Science of Term Structure Models</title>
<meta name="description" content="Financial Risk Manager Part 2 Study Materials">
<meta name="author" content="MacLane Wilkison">
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<body>
<div class="reveal">
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<div class="slides">
<section>
<h1>Chapter 3</h1>
<h3>The Science of Term Structure Models</h3>
<p>
<small>Created for <a href="http://alchemistsacademy.com">Alchemists Academy</a> by <a href="http://alchemistsacademy.com/about">MacLane Wilkison</a></small>
</p>
</section>
<section>
<h2>Rate and Price Trees</h2>
<img src="images/MRMM3/price-tree.png" alt="illustrative binomical pricing tree" />
</section>
<section>
<h2>Aribtrage Pricing of Derivatives</h2>
<ul>
<li>Aribtrage pricing is done by finding and pricing a security's replicating portfolio</li>
<li>For derivatives, this is complicated by the fact that cash flows depend of the level of interest rates</li>
<li>The probabilities of up or down moves are of NOT considered in the calculation</li>
</ul>
</section>
<section>
<h2>Risk-Neutral Pricing</h2>
<p><em>Definition: A technique that modifies an assumed interest rate process so that any contingent claim can be priced without having to construct and price its replicating portfolio</em></p>
<ul>
<li>Probability of up-state: <em>p</em></li>
<li>Probability of down-state: <em>(1-p)</em></li>
</ul>
</section>
<section>
<h2>Aribtrage in a Multi-Period Setting</h2>
<ul>
<li>Recombining vs. non-recombining trees</li>
<li>State-dependent volatility</li>
<li>Drift</li>
</ul>
<aside class="notes">
In recombining trees, the up-down and down-up states have the same value. In non-recombining trees, they do not. State-dependent volatility describes a volatility process that depends on the level of rates. The difference between the true and risk-neutral probabilities is referred to as the drift.
</aside>
</section>
<section>
<h2>Option-Adjusted Spread</h2>
<p><em>Definition: The spread such that the market price of a security equals its model price when discounted values are computed at risk-neutral rates plus that spread</em></p>
<ul>
<li>A positive OAS suggests the security trades cheaply</li>
<li>A negative OAS suggests the security trades dearly</li
</ul>
</section>
<section>
<h1>THE END</h1>
<h3><a href="http://alchemistsacademy.com">AlchemistsAcademy.com</a></h3>
</section>
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