Editor’s Letter

WHAT DOES IT ALL MEAN?

It is not hard to see lots of reasons to be highly uncertain about what the immediate future holds—in Europe, in the United States, across the Arab world, in China, and pretty much everywhere else. The list of physical and man-made real and potential disasters keeps growing, and each day seems to bring into focus one or more major issues, all of which are capable of causing huge economic effects. Will Europe agree on a bailout plan for Greece or will Slovakia balk at bailing out their wealthier but profligate neighbors? If they agree to the bailout, will Greek citizens (and Italians, Spaniards, Portuguese…) tolerate the austerity their leaders are being forced to accept in return? Will the politics surrounding next year’s U.S. election paralyze policymaking in Washington for the next year? What will China do about its inflation and its currency? The market grasps at shreds of evidence and responds in extreme fashion, bouncing from optimism that things will work out somehow to pessimism that they won’t. And we can expect to keep bouncing until the underlying issues come closer to some resolution.

While waiting for that to happen, let us turn our attention to this issue of The Journal of Derivatives. It begins with a fresh attack on what has nearly become the Holy Grail of interest rate derivatives research: reconciling the pricing of interest rate caps and swaptions within the same model. Payoffs for both kinds of instruments are determined by the same future interest rates, so the valuation models really ought to be consistent with each other. But real-world prices don’t cooperate. Rebonato and Pogudin’s approach uses cap contracts to derive an upper bound on the possible value of a swaption whose payoffs span the same future time periods. With considerable effort, they are able to fit both cap and swaption values with swaptions close to the no-arbitrage boundary most of the time but penetrate it only occasionally for brief periods. But fitting current prices entails building implausible future price behavior into the model. At the end of their analysis, the problem still exists, but insight has been shed on how hard it will be to devise a Grand Unified Theory of real-world cap and swaption valuation.

The next article also examines swaptions, but they are commodity swaptions in this case. Valuation models now need to deal with the dynamics of the term structures of both forward commodity prices and forward interest rates. Luckily, it has not yet become necessary to reconcile commodity cap and swaption pricing. The standard valuation technique is computer-intensive, Monte Carlo simulation. Larsson proposes an approximation for one key step in the modeling that leads to closed-form pricing equations and an orders-of-magnitude reduction in execution time.

Next, Ritter, Musshoff, and Odening offer a look at the information content of weather derivatives, specifically, futures contracts tied to average temperatures in three major U.S. cities. As anyone who has ever planned a picnic knows, while we may know something about the general properties of climate—it tends to be colder in the winter than in the summer, for example—tomorrow’s weather is hard to predict accurately, and the accuracy of forecasts for more than a few days ahead diminishes rapidly. A typical approach to pricing weather futures is to fit time series models on past temperature data, to allow for seasonal patterns and short-run serial correlation. The article explores how much extra information can be added by incorporating meteorological forecasts from the weather service. Weather forecasts help considerably, but only when the contracts approach expiration.

Retail investors seem to have enormous affection for securities that have unlimited, or at least large, upside potential but limited possibility of loss on the downside. Numerous securities (e.g., put options), trading strategies (e.g., portfolio insurance), and structured products (e.g., principal-protected notes) have been devised in response. Some of the structures are so complicated that the typical investor may have little ability to analyze them or understand them fully. Here, Deng, Guedj, Mallett, and McCann consider principal-protected absolute return barrier notes, which promise full repayment of principal plus interest at a rate that depends in an odd way on how far an underlying stock index has moved from its initial level over the life of the contract. Determining fair value for the notes is not easy, so it is not surprising that customers end up paying more than the payoffs are worth.

The final article discusses a set of issues that is becoming increasingly important in emerging financial markets around the world—how to reconcile derivatives with sharia law in Muslim finance. The key questions are how to handle these instruments within the strictures of sharia or, alternatively, how to provide the same functions in different ways that are not prohibited. One idea promoted by Western financial institutions is based on a kind of total return swap, which can theoretically transform any kind of cash flow into another, in this case, from a prohibited activity into an allowed one. Atallah and Ghoul argue, however, that this attempt to sidestep the rules is not likely to satisfy the religious authorities that worry about both the letter and the spirit of the law.

Well, with no apparent resolution in sight any time soon of any of the many uncertainties that are buffeting the markets, we had better buckle our seatbelts. We may end up going nowhere, as over the past several months, but it is likely to be a bumpy ride along the way.

TOPICS: Options, simulations, futures and forward contracts

Stephen Figlewski

Editor