Mark-to-market pricing of financial instruments plays an important role in managing risk. Asset managers and other industry practitioners depend on accurate valuations of financial instruments to assess the impact of risk factor changes on their portfolios. But the ability to accurately calculate exposures is challenged by highly dynamic, frequently fluctuating markets. Market standard valuation techniques such as Monte Carlo aren’t always efficient for such assets. Certain derivative instruments, such as Asian spread options, are a case in point. These instruments require a more robust valuation approach.
SS&C Algorithmics launched a closed-form methodology for Asian spread options based on moment-matching, a solution that works well for a wide range of input parameters.
Read our "Closed-form Valuation of Asian Spread Options" whitepaper for an in-depth discussion on how we use a closed-form process to calculate prices and run risk-factor models. The paper presents the approach and analysis of outputs against a Monte Carlo approach. Both prices and sensitivities for our formula were shown to work well when compared to Monte Carlo benchmark results.
Why Consider A Closed-Form Model
As noted above, volatility presents both the need and the obstacle for certain assets. Accurately and quickly calculating the impact of pricing changes is critical to identifying trading triggers and gauging portfolio risk. The effectiveness of traditional methodologies (such as Monte Carlo simulation) depends on the ability to obtain a large sampling of regular data points and to run thousands—or sometimes millions—of calculations.
But a Monte Carlo simulation becomes less useful when multiple pricings of the financial instrument are required in a short time frame. Adequate data isn’t available quickly enough; delayed risk factor outputs can end up being stale and useless.
The most time-efficient route for the valuation of financial instruments is the closed-form solution. This approach is the preferred methodology for the valuation of derivative instruments such as Asian spread options, an instrument that has recently gained more popularity in the energy markets.
Asian spread options are European call/put options on the spread between the time average of two underlying assets. Those underlying instruments could belong to a variety of asset classes. The spread, for example, can be defined between the raw and the refined commodity product, or between the prices of a similar commodity in two different geographies. Taking the average price of a commodity reduces the impact of market volatility and makes the derivative instrument more appealing to investors in energy markets.
Underlying Calculations: Transparency and Testing
Some providers in the market offer alternative pricing models for Asian spread options, but the underlying calculations are “black-box” and not always publicly available. A lack of transparency poses a risk of its own. Without visibility into the framework, the value and volume of data, and the data sensitivities, it can be difficult to assess the true accuracy and thus the effectiveness of a computation. Undoubtedly, a benefit of utilizing Monte Carlo is that the risk factors, underlying pricing methodology and calculations are known, and thus transparent. But, as pointed out above, Monte Carlo simulations can be less effective for instruments with rapid price changes or a smaller data set. An answer is an alternative approach where the methodology details are both disclosed and tested.
In our latest paper, we present the underlying technical calculations for using a closed-form methodology, allowing risk and portfolio managers to fully and accurately understand the pricing of complex derivative instruments such as Asian spread options. We’ve also tested our findings against the results of a Monte Carlo simulation, and present a comparison of these findings. These findings confirm that our closed-form solution is an effective alternative.
About SS&C Algorithmics
Modeling for Asian spread options and other asset classes are embedded in SS&C Algorithmic’s Riskwatch platform, an advanced simulation engine at the core of SS&C's risk analytic capabilities. Riskwatch is a proprietary engine that provides a real-time valuation for various global financial instruments and asset classes. It can model and value an entire portfolio today and at time points in the future throughout the lifetime of the transactions. By leveraging patented mark-to-future technology, clients can meet regulatory and business needs for market risk, counterparty credit risk, asset and liability management, liquidity risk solvency II, 18f-4 VaR for asset managers and pension funds as well as a complete stress-testing framework. Riskwatch is available on the cloud via SS&C Algorithmics Financial APIs.
To read about our methodology and pricing analysis in greater detail, download our "Closed-form Valuation of Asian Spread Options" whitepaper, or visit the Algorithmics page.
Written by Ken Wong
Sr. Manager, Financial Engineering, SS&C Algorithmics, Product Feasibility & Design