| dc.description | Executive Summary
The objective of this project is to try and price a Quanto-Credit Default Swap,- a cross-currency derivative which has payoffs defined in dollar but made in yen. We go about it by assessing the default and cumulative probability curves for the dollar credit spreads in our default swap. This would lead us to arrive at the DVO1, the dollar value of one basis point. Different scenarios are to be generated for various assumptions of recovery values.
This would help in determining the dollar value of a per cent of recovery value. Then we try and find the NPV to the buyer of the credit default swap under a few scenarios of cred it spreads and recovery values. The cost to hedge the quanto risk arising out of the yen payments has to be quantified. For this purpose the various risks are enumerated and quantified for a simple currency swap. From this the case for a quanto risk price was built. A hedge is then constructed for a position against all the “individual risks using instruments solely available in the North American and London markets. We achieve this by mathematically modeling our case. We go about this by constructing a portfolio of assets and corresponding positions to hedge the risks arising out of them. Then we use Taylor's series expansion to determine the hedge parameters for a change in the value of the portfolio. Then we need to be able to determine the value of the underlying variables at maturity (a range within which each individual variable is likely to fall). This we do by applying Ito's lemma to the underlying variables, which are generalized Wiener processes. Ito's lemma is nothing but an extension of the Taylor series expansion. This were used to generate scenarios, which gave us an idea as to the expected losses we might be bearing, and how much we would like to be compensated.
These results were compared against what is happening in the market. This served as a validation for our model and gave us feedback as to the corrections required. | en_US |
