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As above, these methods can solve derivative pricing problems that have, in general, the same level of complexity as those problems solved by tree approaches, [1] but, given their relative complexity, are usually employed only when other approaches are inappropriate; an example here, being changing interest rates and / or time linked dividend policy.
(Note that the alternative valuation approach, arbitrage-free pricing, yields identical results; see “delta-hedging”.) This result is the "Binomial Value". It represents the fair price of the derivative at a particular point in time (i.e. at each node), given the evolution in the price of the underlying to that point.
From the economic point of view, financial derivatives are cash flows that are conditioned stochastically and discounted to present value. The market risk inherent in the underlying asset is attached to the financial derivative through contractual agreements and hence can be traded separately. [11] The underlying asset does not have to be acquired.
More generally though, simulation is employed for path dependent exotic derivatives, such as Asian options. In other cases, the source of uncertainty may be at a remove. For example, for bond options [ 3 ] the underlying is a bond , but the source of uncertainty is the annualized interest rate (i.e. the short rate ).
In finance, an interest rate derivative (IRD) is a derivative whose payments are determined through calculation techniques where the underlying benchmark product is an interest rate, or set of different interest rates. There are a multitude of different interest rate indices that can be used in this definition.
A delta one product is a derivative with a linear, symmetric payoff profile. That is, a derivative that is not an option or a product with embedded options. Examples of delta one products are Exchange-traded funds, equity swaps, custom baskets, linear certificates, futures, forwards, exchange-traded notes, trackers, and Forward rate agreements ...
C. Calendar spread; Callable bull/bear contract; Capital guarantee; Cash flow hedge; Cashflow matching; CDO-Squared; Chain of Blame; Chan–Karolyi–Longstaff–Sanders process
Given this functional link to volatility, note now the resultant difference in the construction relative to equity implied trees: for interest rates, the volatility is known for each time-step, and the node-values (i.e. interest rates) must be solved for specified risk neutral probabilities; for equity, on the other hand, a single volatility ...