Editor’s Letter

Former New York City Mayor Ed Koch was famous for stopping people on the street to ask: “How’m I doing?” These days, the whole country is asking the same question of Ben Bernanke, Tim Geithner, and the other stewards of the economy, who are all attempting to lead us out of the depths of financial meltdown on to the high ground of economic recovery. The current answer to how we’re doing is that maybe some “green shoots” are beginning to be visible, as evidenced by statistics indicating that we might no longer be in free fall. We’re still hurtling downward, of course, but the rate of collapse may be slowing. It is sobering that we’re reduced to celebrating the possibility that the second derivative of the economy may have turned from negative to mildly positive.

The beginnings of the financial crisis were seen in 2007 in the market for collateralized debt obligations (CDOs) tied to mortgage loans. Modeling risk exposure for credit derivatives, and the losses distributions for CDO portfolios in particular, has been a hard problem all along, but the shortcomings of the standard models became all too apparent as default rates rose. One of the biggest factors was that both tail risk and default correlations turned out to be much higher than what had been expected. The first paper in this issue, by Burtschell, Gregory and Laurent, compares the theoretical behavior and empirical performance of a number of alternative CDO models. They obtain interesting general theoretical results, like a monotonic relation for some of the specifications between relative tranche values and a single correlation measure, as well as valuable empirical evidence, like the observation that fat-tailed distributions for the risk factors are better at fitting market data on tranche prices. The next paper also examines differences between standard pricing models and market behavior, in the form of the skewness of stock returns distributions as implied by options prices. It is well-known that realized stock returns tend to be negatively skewed, and risk-neutralization increases negative skewness. Taylor, Yadav and Zhang explore the regular properties of this phenomenon.

The other articles in this issue present new valuation approaches for several kinds of derivative instruments. The third paper, by Benner, Zyapkov and Jortzik, addresses the problem of cross-currency interest rate products, for which it is necessary for the model to be simultaneously consistent with the levels and dynamics of the term structures in both countries as well as the exchange rate between them. After that, Li and Zhao present a clever new way to apply results from theoretical combinatorics to a binomial lattice in order to value Parisian options, which are subject to relatively complicated path-dependence. Finally, Moraux offers an analysis and a new valuation approach for perpetual American strangles, another path-dependent contract that combines a perpetual call and a perpetual put, with the provision that when one option is exercised the other expires worthless.

When I finished writing the last Editor’s Letter, for the Spring 2009 JOD a few months ago, we were all hunkered down, expecting that things were likely to get worse before they got better, and hoping that we wouldn’t have to wait too long for the regime shift to occur. Well we’re still hunkered down…but…is that a green shoot I see?!

I hope so! But while we’re holding our breath waiting to see if it takes root and grows, it is that time of year once again to celebrate an event whose occurrence is settled: We congratulate all of the students who are graduating this spring! (and wish them good luck as they confront a difficult job market). And, as usual, we also congratulate their parents, both for their children’s achievements and also for the fact that they can finally stop making those tuition payments.

TOPICS: Options, CLOs, CDOs, and other structured credit, financial crises and financial market history

Stephen Figlewski

Editor

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