Structured finance: the object oriented approach

Umberto Cherubini, Giovanni Della Lunga0470026383, 9780470026380, 9780470512722

Structured Finance: The Object Orientated Approach is aimed at both the finance and IT professionals involved in the structured finance business with the intention of sharing common concepts and language within the industry. The financial community (structurers, pricers and risk managers) view structured products as collections of objects under the so-called replicating portfolio paradigm. The IT community use object oriented programming (OOP) techniques to improve the software updating and maintenance process. For them structured products are collections of objects as well. Despite use of the same object concept, it looks like communication between these different professional functions has been problematic. Recently, construction of standard data structures known as FpML has begun to lay out a common definition of objects, at least for plain vanilla derivatives, both between IT and financial people and across different market players. Along this line, this book builds upon the concept of object to provide frontier treatment of structured finance issues relevant to both communities engaged in building, pricing and hedging products and people engaged in designing and up-dating the corresponding software. 
Structured Finance: The Object Orientated Approach will enable you to:  decompose a structured product in elementary constituent financial objects and risk factors (replicating portfolio) understand the basics of object oriented programming (OOP) applied to the design of structured cash flows objects build your own objects and to understand FpML data structures available for standard products gauge risk exposures of the objects in structured products to: risk factors, their volatilities and the correlation among them (which factor are you long/short? Are you long/short volatility? Are you long/short correlation?) update your risk management system to accommodate structured products with non linear exposures and to design objects to represent, price and hedge, counterparty risk 

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Table of contents :
Structured Finance……Page 4
Contents……Page 8
1.1 Introduction……Page 14
1.2 Arbitrage-free valuation and replicating portfolios……Page 15
1.3.2 Nonlinear derivatives……Page 16
1.4.1 Univariate claims……Page 18
1.4.2 Multivariate claims……Page 20
1.5 The structuring process……Page 21
1.5.2 Risk factors, moments and dimensions……Page 22
1.5.3 Risk management……Page 24
1.6.1 Contingent coupons and repayment plans……Page 26
1.6.3 Exposure to volatility……Page 27
1.7 Structured finance and object-oriented programming……Page 28
References and further reading……Page 30
2.2 What is OOP (object-oriented programming)?……Page 32
2.3.1 A simple example……Page 33
2.4.1 The Unified Modelling Language (UML)……Page 38
2.4.2 An object-oriented programming language: Java……Page 39
2.5.1 Abstraction……Page 40
2.5.3 Attributes and operations: the Encapsulation principle……Page 41
2.5.5 Inheritance……Page 42
2.5.7 Associations……Page 47
2.5.10 Polymorphism……Page 50
References and further reading……Page 55
3.2 Volatility and correlation: models and measures……Page 58
3.2.3 Realized (cross)moments……Page 60
3.3 Implied probability……Page 61
3.4.1 Implied volatility……Page 63
3.4.2 Parametric volatility models……Page 64
3.4.3 Realized volatility……Page 67
3.5.1 Forex markets implied correlation……Page 68
3.5.3 Credit implied correlation……Page 69
3.6.1 Multivariate GARCH……Page 70
3.6.2 Dynamic correlation model……Page 71
3.7.1 Copula functions: the basics……Page 72
3.7.2 Copula functions: examples……Page 73
3.7.3 Copulas and survival copulas……Page 74
3.7.4 Copula dualities……Page 75
3.8 Conditional probabilities……Page 76
3.9 Non-parametric measures……Page 77
3.10 Tail dependence……Page 78
3.11.1 Correlation asymmetry: finance……Page 79
3.12 Non-exchangeable copulas……Page 81
3.13 Estimation issues……Page 83
3.14 Lévy processes……Page 84
References and further reading……Page 85
4.1 Introduction……Page 88
4.2.3 Equity-linked notes……Page 89
4.2.5 Asset-backed securities……Page 90
4.3.1 Payment date conventions……Page 91
4.3.2 Day count conventions and accrual factors……Page 92
4.4.1 Date handling in Java……Page 93
4.4.2 Data models……Page 98
4.4.3 Design patterns……Page 111
4.5 Cash flow generator design……Page 112
4.5.1 UML’s activity diagram……Page 113
4.5.2 An important guideline to the data model for derivatives: FpML……Page 116
4.5.3 UML’s sequence diagram……Page 122
4.6 The cleg class……Page 123
References and further reading……Page 124
5.2 Object-oriented structuring process……Page 126
5.3 Contingent repayment plans……Page 127
5.3.1 Payoff class……Page 128
5.4.1 Exercise class……Page 130
5.6.1 Contingent convertibles: Co.Cos……Page 134
5.6.2 Contingent reverse convertibles……Page 135
5.6.4 Parisian option: a short description……Page 136
5.7.1 Valuation methods for barrier options: a primer……Page 138
5.7.2 The Strategy Pattern……Page 139
5.7.3 The Option class……Page 140
5.7.4 Option pricing: a Lego-like approach……Page 142
References and further reading……Page 148
6.2 Single coupon products……Page 150
6.2.1 Crash protection……Page 151
6.2.2 Reducing funding cost……Page 154
6.2.3 Callability/putability: compound options……Page 155
6.3 Smoothing the payoff: Asian options……Page 163
6.3.1 Price approximation by “moment matching”……Page 164
6.3.2 Variable frequency sampling and seasoning process……Page 165
6.4.1 Digital notes……Page 166
6.4.3 Forward start options……Page 167
6.4.4 Reverse cliquet notes……Page 168
6.5.1 The AND/OR rule……Page 169
6.5.2 Altiplanos……Page 170
6.5.3 Everest……Page 171
6.5.4 Basket notes……Page 173
6.6.1 Major components of a Monte Carlo algorithm……Page 174
6.6.2 Monte Carlo integration……Page 175
6.6.3 Sampling from probability distribution functions……Page 176
6.6.4 Error estimates……Page 177
6.6.5 Variance reduction techniques……Page 178
6.6.6 Pricing an Asian option with JMC program……Page 182
References and further reading……Page 188
7.2 Defaultable bonds as structured products……Page 190
7.2.2 Credit spreads……Page 191
7.3 Credit derivatives……Page 192
7.3.1 Asset swap spread……Page 193
7.3.2 Total rate of return swap……Page 194
7.3.3 Credit default swap……Page 195
7.3.4 The FpML representation of a CDS……Page 197
7.4 Credit-linked notes……Page 200
7.5 Credit protection……Page 201
7.6 Callable and putable bonds……Page 203
7.7.1 Structural models……Page 204
7.7.2 Reduced form models……Page 206
7.8.1 Security-specific information: asset swap spreads……Page 209
7.8.2 Obligor-specific information: equity and CDS……Page 210
References and further reading……Page 214
8.2 Basket credit derivatives……Page 216
8.3.1 Independent defaults……Page 217
8.3.2 Dependent defaults: the Marshall–Olkin model……Page 218
8.3.4 Factor models: conditional independence……Page 220
8.4.1 Monte Carlo simulation……Page 224
8.4.2 The generating function method……Page 225
8.5.1 CDO: general structure of the deal……Page 226
8.5.2 The art of tranching……Page 228
8.5.3 The art of diversification……Page 230
8.6 Standardized CDO contracts……Page 232
8.6.1 CDX and i-Traxx……Page 233
8.6.2 Implied correlation……Page 234
8.6.3 “Delta hedged equity” blues……Page 235
8.7 Simulation-based pricing of CDOs……Page 237
8.7.1 The CABS (asset-backed security) class……Page 238
8.7.2 Default time generator……Page 240
8.7.3 The waterfall scheme……Page 241
References and further reading……Page 243
9.1 Introduction……Page 246
9.2 OTC versus futures style derivatives……Page 247
9.3 Value-at-risk & Co…….Page 248
9.3.1 Market risk exposure mapping……Page 249
9.3.2 The distribution of profits and losses……Page 250
9.3.3 Risk measures……Page 251
9.4 Historical simulation……Page 252
9.4.1 Filtered Historical Simulation……Page 253
9.4.2 A multivariate extension: a GARCH+DCC filter……Page 254
9.5 Stress testing……Page 255
9.5.2 Consistent scenarios……Page 256
9.5.3 Murphy’s machines……Page 259
9.6.1 Effects of counterparty risk……Page 260
9.6.2 Dependence problems……Page 266
9.6.3 Risk mitigating agreements……Page 267
9.6.4 Execution risk and FpML……Page 271
References and further reading……Page 272
Appendix A Eclipse……Page 274
Appendix B XML……Page 278
Index……Page 296