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June 2008 |
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In this issue we discuss and provide insight into - Valuation of equity derivatives with a volatility surface specification. -
Risk-free versus risky volatility
specification for convertible securities. Visit us on the web:E-Mail your suggestions and comments to: Copyright © 1996 - 2008 |
We are pleased to announce the release of support for volatility
surfaces for the pricing of convertible securities and equity options.
Specifying a volatility surface that captures your view of the implied
volatility in the market will result in the following benefits: -
Precise control over the valuation of equity options and the
convertible securities. -
Obtain a Delta profile for hedging that reflects your view of the
relationship between spot prices, strikes, expirations and implied
volatilities. We analyzed several instruments (equity options and convertibles) with
flat volatilities and volatility surfaces, and we present a summary of our
observations below: ·
The effect of the skew in the volatility surface on the valuation is
more pronounced as the time to expiration increases. This is especially true
for long dated equity options and long call protected convertible securities
that have been coming to market in the past year. We strongly recommend the
specification of volatility surfaces for valuing convertible securities with
over three years of call protection. ·
Volatility surface is a better way to capture skew in valuing mandatory
convertibles. If the mandatory convertible has structural features such as
calls, and one-to-one upside participation that make a simple decomposition
difficult, volatility surfaces is the only way to capture the skew in
valuation. ·
Volatility surface is a better way to value convertibles with variable
conversion ratio (aka embedded warrants) features. You can specify a surface
that captures the appropriate volatilities for the complex set of options
that get embedded into a convertible security with the variable conversion
ratio feature. Risky Vs
Risk-free Volatility We present a discussion on the characteristics of the option embedded in a convertible security. Below is a summary of our conclusions. - Visualizing a convertible security to be made up of stock, plus a European put, plus coupons provides a realistic view of the option embedded in a convertible security. - The implied volatility computed via risky model should not be compared to risk-free implied volatilities observed in the options market. We are pleased to provide an approximate risk-free volatility for the embedded option in a convertible valued via a risky-model. - If you specify a risk-free volatility as input to the model, you must also specify the bankruptcy-mode with an appropriate decay factor to capture the riskiness of the option embedded in a convertible. |
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