FM HOMEWORK Harvard Case Solution & Analysis

FM HOMEWORK Case Study Solution

Question 1

There are different kinds of risks in bonds such as the credit default risks, call risks, reinvestment risk, interest rate risk etc. This is the reason that we mean corporate bonds whenever we say credit default risk. Therefore, despite the higher standard deviation of the corporate bonds as compared to the government bonds, we cannot confer that this consensus is right because corporate bonds can never be less risky as compared to the government bonds and the reason for this is that there is no credit risk in government bonds as the government backs the US treasury while there is credit risk in corporate bonds and the company can also go bankrupt.

This also explains the growth of the credit derivatives over the years because the bond investors don’t want to take the default risk and this risk is transferred to a third party. Lastly, the corporate bond prices fail to capture the credit default swap pricing because of the market inefficiencies and the risk of default of either of the parties in the contract.

Question 2

The comparison of equity and fixed income option assumptions is as follows:

  • Interest rates are assumed to be held constant in equity options while this is not true for fixed income options due to the changes in the yield curves.
  • The volatility is assumed to be constant in equity options in short term and long term however, in fixed income options this is not possible due to the first reason.
  • The equity options assume that the markets are perfectly liquid however, fixed income options cannot be sold or purchased at any given point of time.

The implications based on the above differences for the trading models is that these models should be adjusted for the underlying assumptions of equity options and fixed income options and different models should be formulated. Lastly, the Black Scholes model can only value stock options because it fails to capture the stochastic process for fixed income as the model is only related to the long returns of the stock prices.

FM HOMEWORK Harvard Case Solution & Analysis



Question 3

The advantages of using realized volatility or standard deviations for pricing the options is that the implied volatility follows a pattern that is predictive and it confirms with the existence of the contemporaneous relationships between the index returns and the implied volatility. On the other hand, the advantage of using GARCH for pricing the options is that it factors the value at risk and the research also shows that GARCH dominates the benchmark Black Scholes model based on the fit of the model to the observed prices.

GARCH is becoming more popular in the recent decade because it generates close to real option prices and accurate values. Secondly, with the modifications the GARCH is reaching very far because this model has the ability of becoming more volatile during the financial crisis period and less volatile during steady economic growth and period of relative calmness.........................

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