Recent advances in financial derivatives


Managerial Finance

ISSN: 0307-4358

Article publication date: 27 September 2011



Liu, S. and Sathye, M. (2011), "Recent advances in financial derivatives", Managerial Finance, Vol. 37 No. 11.



Emerald Group Publishing Limited

Copyright © 2011, Emerald Group Publishing Limited

Recent advances in financial derivatives

Article Type: Guest editorial From: Managerial Finance, Volume 37, Issue 11

About the Guest Editors

Shuangzhe LiuAssociate Professor in Statistics and Econometrics at the University of Canberra. Dr Liu was awarded his doctorate at Tinbergen Institute, University of Amsterdam, and then worked at University of Basel and Australian National University. He was a Visiting Scholar at Keio University, Visiting Associate Professor at Kyoto University and Visiting Professor at Dortmund University. Dr Liu has published on issues in modelling and evaluation of derivatives among others in Financial Modelling and Econometrics.

Milind SathyeProfessor of Banking and Finance at the University of Canberra. Prior to coming to academics Professor Sathye worked for over two decades in the banking industry. He is often consulted by the Australian Senate Economics Committee as well as by the Australian and international media on banking and finance issues. Professor Sathye has published on a wide range of topics in banking and finance area including derivatives in leading international journals.

In the last two years, financial derivatives were blamed by many as direct or indirect causes of the 2008-2009 global financial crisis. The collapse of Enron was also partially blamed on the valuation of derivative instruments. Yet, derivatives are considered to be a major milestone in financial engineering and volume of trading continues to rise. In 2009, for example, 1.7 billion contracts were traded on Eurex – one of the leading derivative exchanges in the world. As we write, the financial markets are still strongly volatile amid concerns that another wave of recessions are looming. This special volume on financial derivatives is therefore topical.

We received a large number of papers and selected the eight best for inclusion in this volume based on referee comments and our own review. The contents of this issue reflect the richness in diversity and the innovativeness in methodology called for to correctly analyse and best use financial derivatives. The papers in this issue deal with theoretical or methodological aspects, but all have applications in view, and some contain illustrations of the applied techniques. They may be broadly summarised as follows.

In “Bond valuation under a discrete-time regime-switching term-structure model and its continuous-time extension”, the authors consider a discrete time, Markov, regime switching, affine term-structure model for valuing bonds and other interest rate securities. They derive a simple way to give exponential-affine forms of bond prices using backward induction. They also consider a continuous-time extension of the model and derive exponential-affine forms of bond prices.

In “Coherent risk measure for derivatives under Black-Scholes economy with regime switching”, the authors consider a scenario-based risk measure for a portfolio of European-style derivative securities over a fixed time horizon under the regime-switching Black-Scholes economy. Their idea and results are an extension of an early paper by Yang and Siu (2001). They present closed-form expressions for the European and barrier options and provide some insights on risk management of portfolios with derivatives.

In “Traded American options are Bermudan”, the authors study the importance of business time and market opening/closing times and days for American option pricing. They find that the potential biases that can arise from ignoring the non-continuous operation of the market are not negligible.

In “Using Black-Scholes to determine an optimal funding term”, the author examines the use of the Black-Scholes risky asset model to determine choice of optimal investment term in a reinvestment chain model. For annual returns data for the all ordinaries accumulation index for the years 1900-2009 used for an empirical assessment of the relative usefulness of two criteria, the author finds empirical evidence that favours use of the criterion without the no-arbitrage assumption.

In “A Three-factor valuation model for mortgage-backed securities (MBS)”, the authors generalise the one-factor mortage-backed securities (MBS)-pricing model proposed by Kariya and Kobayashi (2000). The structure, rationality, and potential for practical use of their model are demonstrated by valuing an MBS via Monte Carlo simulation and then conducting a comparative statics analysis.

In “Weather risk swap valuation”, the author develops a theoretical framework to evaluate the fairness or rationality of a zero-cost weather risk swap, derives some conditions to check the rationality and empirically evaluates the fairness of the above temperature risk swap between two companies.

In “Estimating the leverage parameter of continuous-time stochastic volatility models using high frequency S&P 500 and VIX”, the authors propose a new method for estimating continuous-time stochastic volatility (SV) models for the S&P 500 stock index process using intraday high-frequency observations of both the S&P 500 index and the Chicago Board of Exchange implied volatility index (VIX). They show that, under an SV model without measurement errors, the realised co-variation of the price and VIX processes divided by the product of the realised volatilities of the two processes, converges to the leverage parameter in probability as the time intervals between observations shrink to zero, even if the length of the whole sample period is fixed.

In “Risk management of risk under the Basel accord: forecasting value-at-risk of VIX futures”, the authors address the question of risk management, namely VaR of VIX futures prices, and examine how different risk management strategies performed during the 2008-2009 global financial crisis. They find that an aggressive strategy of choosing the supremum of the single model forecasts is preferred to the other alternatives, and is robust during the global financial crisis.

We hope that this issue will provide the researchers and practitioners with the state-of-art research in the financial derivatives area and introduce them to the new and innovative techniques and applications of financial derivatives.

We thank Professor Don Johnson for his strong support and useful advice. We also thank Sarah Roughley, Sophie Barr, Andrea Watson-Lee and Kelly Dutton at Emerald for their efficient assistance in the process of editing and managing the manuscripts. We are very grateful to the referees for their careful evaluations and constructive comments. Finally, we are deeply obligated to the authors for submitting their manuscripts and for their understanding and collaborations through the entire process of making this issue.

Shuangzhe Liu, Milind SathyeGuest Editors

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