AVP - Pricing Models - BFS

What we are looking for in Pricing Models , a small write-up:

Investment banks use various pricing models to determine the fair value of financial instruments and derivatives. The choice of a particular model depends on the type of financial product, market conditions, and the complexity of the instrument. Here are some common pricing models from an investment bank perspective:

Black Scholes Model

Purpose: Pricing European-style options

Application: Equity options, index options

Key Factors: Underlying asset price, option strike price, time to expiration, volatility, risk-free interest rate

Binomial Option Pricing:

Purpose: Pricing options using a binomial tree.

Application: Options, especially American-style options

Keywords: Similar to Black-Scholes but discretized over time

Monte Carlo Simulation:

Purpose: Pricing complex derivatives by simulating multiple future scenarios.

Application: Exotic options, path-dependent derivatives

Keywords: Random sampling of future prices, option payoff calculation

Interest Rate Models (e.g. Vasicek, Hull - White

Purpose: Pricing interest rate derivatives

Application: Interest rate swaps, caps, floors

Key Factors: Current interest rate, mean reversion, volatility

Credit Default Swaps (CDS Models) :

Purpose: Pricing credit derivatives

Application: Credit default swaps

Key Factors: Probability of default, recovery rate, credit spreads

Structured Product Models

Purpose: Pricing complex structured products

Application: Collateralized debt obligations (CDOs), mortgage-backed securities

Key Factors: Underlying assets, correlation, tranche structures

Commodities Pricing Models

Purpose: Pricing commodity derivatives

Application: Energy, metals, agricultural commodities

Key Factors: Spot prices, forward curves, storage costs.

Foreign Exchange Models

Purpose: Pricing currency derivatives

Application: Currency options, currency swaps

Key Factors: Spot exchange rates, interest rates in different currencies, volatility

Real Options Model

Purpose: Evaluating strategic investment decisions

Application: Capital budgeting, project finance

Key Factors: Project cash flows, volatility of project value, time to expiration

Equity and Fixed Income Models

Purpose: Pricing equities and fixed-income securities

Application: Stocks, bonds, convertible bonds

Key Factors: Dividends, interest rates, credit spreads