The Pricing of Risk Rate Derivatives and the Implications for Risk Manager

Abstract

The volume and complexity of financial derivatives traded over the counter (OTC) showed in the last two decades a increasing trend. In this context, the interest rate derivatives have a great growth because they are widely used in speculation, arbitrage and hedging strategies. But when the risk rate sensitive derivatives are not a plain vanilla derivatives is not very simple to price them. The second/third generation of interest rate derivatives have, in fact, a complex payoff and a risk profile difficult to quantify. The pricing of risk rate sensitive derivatives of the second/third generation require the use of models able to describe the possible evolution of the term structure of interest rates, during the term of the contract (Short Rate Model and Market Model). In this perspective, the paper: examine the characteristics and limits of applicability of different models of the Short Rate framework for the pricing of interest rate derivatives [Black, 1973, Hull J.C and White 1990]; analyze the theoretical framework of the Market Model and related techniques used to calibrate the model parameters to market data [Stacey A., Joshi 2007,Damiano Brigo, Fabio Mercurio, 2001/2006; Rebonato 2003, Daniel J. Stapleton and Richard C. Stapleton 2003; A. Brace, D. Gatarek, Musiela M. 1996]; analyze, finally, the implications for risk managers involved in managing a interest rate derivatives portfolio.