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
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