International Journal of Theoretical and Applied Finance

In part of the recent financial literature, exotic option pricing models have been built by establishing a link with European-style options. All these models share the characteristic of being consistent with the observed market smile. They differ respect to the specification of the volatility process. This paper provides a deeper insight into the Britten-Jones and Neuberger (1999) smile-consistent no arbitrage with stochastic volatility option pricing model. Their approach is similar, in spirit, to that one of Derman and Kani (1997), but the implementation is simpler and faster. We explain the main features of the model by performing a set of exercises. In addition we propose some extensions of the model, which make it more flexible.

Despite the widespread realization that financial models for contingent claim pricing, asset allocation and risk management depend critically on their underlying assumptions, the vast majority of financial models are based on single probability measures. In such models, asset prices are assumed to be random, but asset price probabilities are assumed to be known with certainty, an obviously false assumption.

We explore practical methods to specify collections of probability measures for an assortment of important financial problems; we provide practical methods to solve the robust financial optimization problems that arise and, in the process, discover "dangerous" measures.

In a behavioural equilibrium exchange rate model, this study investigates the movements of the real exchange rate of the Hong Kong dollar under the currency board arrangement from 1984 to 1998. Cointegration analysis based on Johansen approach is applied to derive the equilibrium real exchange rate in behavioural sense for the Hong Kong dollar. Evidence shows that during the period under investigation, the Hong Kong dollar was initially undervalued when the currency board arrangement was installed. It moved in closer line with the equilibrium rate after 1985 and generally remained moderately undervalued until 1993. Then the currency became overvalued following the upsurge of domestic demand and lingered into 1995 before an adjustment took place latter that year. But except for a few quarters, the overvaluation was not substantial and chronic. On the whole, the Hong Kong dollar seemed to have performed well in the period under examination. In most cases, the currency was actually undervalued. When the Asian financial crisis broke out, the currency was in effect already in a process of adjustment, depreciating form an overvalued level.

We use Principal Component Analysis (PCA) to study the Brady Bond Debt of the four primary Latin American sovereign issuers: Argentina, Brazil, Mexico, and Venezuela. Our dataset covers a period of 5½ years starting in July 1994 and consists of daily sovereign ("stripped") yield levels for the par and discount debt securities of each country. We examine the behavior of the characteristic roots and eigenvectors of the empirical covariance matrices computed sequentially over different periods. We show that, by and large, there exist two statistically significant components, or factors, which explain up to 90% of the realized variance. The eigenvector with largest eigenvalue corresponds to the variance attributable to "regional" ("Latin") risk. The second component strongly suggests the existence of a volatility risk factor associated to Venezuelan debt in relation to the rest of the region. A time-dependent factor analyis reveals that the importance of the variance explained by the factor changes over time and that this variation can be interpreted to some extent in terms of market events. In particular, we investigate the relation between the evolution of the PCA factors with the market dislocations that ocurred during the observation period, including the so-called Tequila effect, Asian flu, Ruble devaluation, and Real devaluation.

An empirical analysis on Eurodollar interest rates daily data in the time period 1990–1996, is performed and compared with Libor data in the time period 1984–1998. The complementary cumulative distributions for the daily fluctuations at different maturity dates and the Power Spectral Density are computed. We find that the probability distribution shows "fat" tails with non-Gaussian behaviours. Moreover, we study the correlations among Eurodollar interest rates fluctuations with different maturity dates. By using an original clustering linkage, we show how the collective motion of the interest rates curve can be analyzed in sub-groups of maturity dates with similar behaviours.