Daily Accrual IR Product

mapleleafs · July 13th, 2006, 6:10 am

For the daily accrual range product, why investor short gamma and vega above accrual level and long when significantly below?what does it mean? i don't get the picturetks

mwc227 · July 29th, 2006, 10:05 pm

Most of time, dealers are buying high striked 'daily digital caplets or floorlets' which is settled on every coupon date in exchange of higher cpn, and as you know digitals are risk reversal products.

toronto · July 30th, 2006, 5:23 am

can you explain a little bit more.........don't get full picture

mwc227 · July 30th, 2006, 9:25 am

Let's say you pay x% coupon as long as index (e.g. LIBOR) remains in the pre-specified range. For sake of understanding you can replicate this payoff by entering underlying swap + digital floorlet (lower barrier) + digital caplet (upper barrier). Of course, this should be daily digital which is delay-settled on next coupon date so it should be convexity adjusted based on your chosen model. Anyhow, if you draw the gamma/vega profile of digital options, you should be able to understand gamma changes its sign around lower/upper barrier levels.