Saturday, October 15, 2011

valuation of various options are more complex than ...

I only know bonds, FX, futures. I feel their valuation is simpler than options.

As stated in http://bigblog.tanbin.com/2011/01/fi-is-more-complex-due-to-time.html, all derivatives have the added complexity of time to maturity. In the same vein, many derivative positions are held "open" longer than cash positions. While open, sensitivity to a lot of variables must be monitored. This is the essence of risk management. Consequence is grave if you neglect these exposures. Valuation is key.

option valuation depends on many (fairly fast-moving) variables
- underlier price swing
- passage of time - theta
- volatility, which is unknown and must be inferred
** volatility itself is a random variable and has a volatility

Option traders not only monitor option valuation, they must monitor delta (#1 sensitivity) and delta's sensitivity. Delta is affected by
- underlier price swing. If you have an open position, and its Delta value is 68%, it won't be valid when underlier drops
- volatility, which is unknown and a guesstimate
- time to maturity. Your 68% will not stay the same tomorrow, even if underlier stays constant

I recently picked up a market maker's brochure on variance swap. Designed for buy-side clients, not quants.
Even the entry-level concepts involve stdev. Since there's a time element, all the vol values need adjustment. Even pnl involves sigma squared.

I was told fixed income is also complex in terms of math, but I feel the entry barrier is a bit higher in this space.

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New York (Time Square), NY, United States
http://www.linkedin.com/in/tanbin