3) Risk Capital- Regulatory & Risk capital under Basel pillar 2 Internal Capital Adequacy Assessment. This includes quantification of risk capital.

4) Stress tests & Scenario Analysis.

On Top of that, A good knowledge of the latest market trends, global and local policy direction, Political risks, Geopolitical risk flashpoints, and be able to map movements in P&L at portfolio and desk level to market events.

Statistics: Posted by Samsaveel — Today, 4:52 am

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What kind of questions should one expect?

Statistics: Posted by zmfactor — February 24th, 2017, 2:59 pm

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There are two P&Ls to think about: Local and Global. Local = mark to market; Global = final, at expiration/closure.

You can change expectation and standard deviations of P&Ls depending on how you hedge. Hedge with real and you get local P&L risk but no global. Hedge with actual you get no local P&L risk but path-dependent global risk. Hedge with other vols and you'll get risk in both.

This reminds me of figures of P&L accumulation (hedging with implied vol vs realised vol) in your "Free Lunch" paper. It is actually the backbone at my desk.

Statistics: Posted by jackgurae — February 24th, 2017, 8:49 am

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That paper of yours (about hedging using realized or implied) is one I share a lot with people, I *leally* love it, it answers questions many people have. Also contract with mixes sign vega and gamma give a very interest twist to this discussion.

Most of my papers are that brilliant and controversial! But that one has captured people's interest more.

What is shocking is that the second bit of math modelling that you learn after Black-Scholes

Statistics: Posted by Paul — February 24th, 2017, 8:32 am

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Thank you for your feedback.

I can't follow. I think choice of hedging vol affect

To my knowledge, it is the level implied vol of option I am holding compared to level of realised vol that affect level of expected P&L.

There are two P&Ls to think about: Local and Global. Local = mark to market; Global = final, at expiration/closure.

You can change expectation and standard deviations of P&Ls depending on how you hedge. Hedge with real and you get local P&L risk but no global. Hedge with actual you get no local P&L risk but path-dependent global risk. Hedge with other vols and you'll get risk in both.

You can also look at maximum and minimum profits.

And all of this depends on the parameters and the sign of gamma.

What is surprising in the analyses that I've done is that indeed expected global P&L is insensitive to what vol you use for hedging. It means that BS is remarkably robust. And it's why using all the fancy stoch vol, calibrated, etc. models is just quant masturbation.

What's more,

I will hedge my Structured Notes product with realised vol (that I assume I know with certainty) because I don't care about P&L swing. Notes are mostly hold to maturity. I do care about variation of expected P&L when Notes die.

If I get loss from hedging, it is mainly because my cost of option is too high (low) if I buy(short) option.

I will hedge SPX option with implied vol because I expect to unwind my position anytime. so I want to make sure that when I want to unwind, P&L will not much swing against me.

Agree. But only because your S&P options each have single-signed gamma always and everywhere.

And there's loads of literature on costs of hedging.

Statistics: Posted by Paul — February 24th, 2017, 8:27 am

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outrun wrote:Maybe a contract that gives you the exact same payoff of a short vanilla option!

This is the feeling this brainteaser left me with, ..it's a word trick.

To some extent it is. But the problem is that traders have all these 'sayings' and 'fixed ideas' that are meaningless..."The market is always right," etc. that stop them thinking. (Yes, I know, thinking is so last century!) So from an educational point of view anything that gets people to stop and question is helpful, even if it's a trick.

I often say in lectures that "I rarely ask difficult questions. They are usually either simple or trick. And if they are simple then you should get the answer right. And if they are trick then I want the wrong answer. So no pressure!"

Education in quant finance is abysmal. (Except the CQF.) The people who want to learn it are often incorrectly prepared. And once they've finished their Masters they think they know everything.

That paper of yours (about hedging using realized or implied) is one I share a lot with people, I *leally* love it, it answers questions many people have. Also contract with mixes sign vega and gamma give a very interest twist to this discussion.

Statistics: Posted by outrun — February 24th, 2017, 8:20 am

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Maybe a contract that gives you the exact same payoff of a short vanilla option!

This is the feeling this brainteaser left me with, ..it's a word trick.

To some extent it is. But the problem is that traders have all these 'sayings' and 'fixed ideas' that are meaningless..."The market is always right," etc. that stop them thinking. (Yes, I know, thinking is so last century!) So from an educational point of view anything that gets people to stop and question is helpful, even if it's a trick.

I often say in lectures that "I rarely ask difficult questions. They are usually either simple or trick. And if they are simple then you should get the answer right. And if they are trick then I want the wrong answer. So no pressure!"

Education in quant finance is abysmal. (Except the CQF.) The people who want to learn it are often incorrectly prepared. And once they've finished their Masters they think they know everything.

Statistics: Posted by Paul — February 24th, 2017, 8:12 am

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jackgurae wrote:But even Binary Option, Gamma can become Positive when option become OTM. That's where delta-hedged positions accumulate loss.

That is why you need to know the difference between hedging using a delta based on actual/real vol versus hedging with implied vol. Hedging with real vol locks in any profit but results in mark-to-market swings in P&L. Hedging with implied eliminates those but leaves exposure to the path and here that would be bad because of OTM negative gamma. In this example you'd therefore hedge with real vol and you'd be fine.

That is one reason why this is a good question. Traders usually hedge with implied vol but in my experience have only the feeblest of understanding of why they do it. If they did that in this example they might indeed lose money. But they needn't.

Thank you for your feedback.

I can't follow. I think choice of hedging vol affect

To my knowledge, it is the level implied vol of option I am holding compared to level of realised vol that affect level of expected P&L.

What's more,

I will hedge my Structured Notes product with realised vol (that I assume I know with certainty) because I don't care about P&L swing. Notes are mostly hold to maturity. I do care about variation of expected P&L when Notes die.

If I get loss from hedging, it is mainly because my cost of option is too high (low) if I buy(short) option.

I will hedge SPX option with implied vol because I expect to unwind my position anytime. I want to make sure that when I want to unwind, P&L will not much swing against me.

Statistics: Posted by jackgurae — February 24th, 2017, 8:05 am

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This is the feeling this brainteaser left me with, ..it's a word trick.

But I agree with Paul's point below!

Statistics: Posted by outrun — February 24th, 2017, 6:59 am

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But even Binary Option, Gamma can become Positive when option become OTM. That's where delta-hedged positions accumulate loss.

That is why you need to know the difference between hedging using a delta based on actual/real vol versus hedging with implied vol. Hedging with real vol locks in any profit but results in mark-to-market swings in P&L. Hedging with implied eliminates those but leaves exposure to the path and here that would be bad because of OTM negative gamma. In this example you'd therefore hedge with real vol and you'd be fine.

That is one reason why this is a good question. Traders usually hedge with implied vol but in my experience have only the feeblest of understanding of why they do it. If they did that in this example they might indeed lose money. But they needn't.

Statistics: Posted by Paul — February 24th, 2017, 6:56 am

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By the way, given that Gamma exposure of Binary Option is very small most of its life and its Risk-Reversal characteristic, does it make Delta-hedging on Binary Option a bad business/strategy?

Statistics: Posted by jackgurae — February 24th, 2017, 2:59 am

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On the other hand if you have access to the history of forward rates and ATM vol, I believe you can get quite creative and you might end up with something interesting, if not useful.

Statistics: Posted by mtsm — February 23rd, 2017, 6:16 pm

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VivienB wrote:How do you calibrate the SABR model if you have only ATM swaptions?

Btw, in the current market situation (i.e. small rates / negative rates), if I had only ATM swaption vols, I would use a Hull-White with a piecewise constant volatility term structure model to extrapolate the vols.

You have a close-form solution of the ATM volatility under the SABR model so provided you have more than 3 ATM market data points you should be able to calibrate alpha, beta and rho.

Regarding the Hull-White approach, the underlying assumption would be to have a surface constant in the strike/moneyness direction and a varying vol in the years to exercise dimension for a specified underlying swap tenor, is that correct?

If I understand correctly, you want to use constant SABR parameters for the entire vol cube? In this case, I'm not sure that the extrapolated surface will be meaningful, but I may be wrong.

Regarding the HW approach, the underlying assumption is [$]dr(t) = [\theta(t) - \kappa r(t)] dt + \sigma(t) dW(t)[$], where [$]\theta[$] is given by the HJM framework, [$]\kappa[$] can be calibrated in the constant vol case, then inputed to bootstrap the function [$]\sigma[$]. In the bootstrap, you find [$]\sigma_{i-1}=\sigma(t_{i-1} < t \leq t_i)[$] that minimize the errors on all swaptions maturing at [$]t_i[$]. If you want to extrapolate swaption prices only at a given tenor, you can replace the minimizations by rootfinders to match the ATM swaption prices with the same tenor.

Statistics: Posted by VivienB — February 23rd, 2017, 5:41 pm

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The SABR model is intended to consolidate the smile risks into three components (vega --- risk to all vols going up and down, vanna --- risk to the skew increasing or decreasing, and volga --- risk to the smile increasing or decreasing). Without implied vols at at least three strikes, one cannot calibrate it from the market. The best one can do is to use proxies to get the SABR parameters ... ie find another market (which has the smile information available), and map the SABR parameters to the market of interest ... usually means taking the same rho and volvol (and beta) values from the proxy instruments. E.g., maybe caplet or bond option markets can be used to suss out the swaption SABR parameters.

WARNING: In principle, this means that one would use the proxy instruments to hedge the vanna and vega risks ,,,

Statistics: Posted by Pat — February 23rd, 2017, 5:25 pm

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swskewgraph.gif

How would determine the "bendy-ness" of the smile if you only have one point (ATM) ?

Maybe not in the case of a single slice indeed, but in general if you have additional constraints on arbitrage-freeness of your whole surface, why not? Furthermore, the ATM level does not correspond to a constant strike as it depends on the years to exercise so you would not even have aligned vol points but sparse points instead.

Statistics: Posted by JejeBelfort — February 23rd, 2017, 5:02 pm

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