How Much Is the Gap? Efficient Jump Risk-Adjusted Valuation of Leveraged Certificates
Quantitative Finance, Vol. 17, No. 9
49 Pages Posted: 2 Feb 2014 Last revised: 4 Jan 2018
Date Written: February 26, 2017
This paper develops a novel and highly efficient numerical algorithm for the gap risk-adjusted valuation of leveraged certificates. The existing literature relies on Monte Carlo simulations, which are not fast enough to be used in a market making environment. This is because issuers need to compute thousands of price updates per second. By valuing leveraged certificates as multi-window barrier options, we explicitly model random jumps that occur at known times, such as between the exchange closing and re-opening. Our algorithm combines the one-day transition probability with Simpson's numerical integration rule. This yields a backward induction scheme which requires a significantly coarser spacial and time grid than finite difference methods. We confirm its robustness and accuracy through Monte Carlo simulations.
Keywords: leveraged certificates, barrier options, overnight gap, risk management
JEL Classification: G13, C63
Suggested Citation: Suggested Citation