Valuation Commentary

Valuation Q&As. Part 1: AD&Co Interest Rate Library
by Alex Levin

Two years ago we published Inquiries & Interactions: We're Always Listening, an overview of commonly asked questions about some features of our valuation analytics. Since then, AD&Co’s OAS system has made huge development strides and its customer base has more than doubled, along with the flow of inquiries seeking analytical advice, or integration help. Questions from users range widely – from simple ones that can be answered in a flash, to complex queries challenging our solutions.

Over the years I referred many clients who’ve asked, “How many paths is enough?” or “What is volatility index?” to this October ’03 article. I decided to revisit this useful article and offer another round of Q&As. My goals are to (A) cover most questions, (B) not repeat or replace our research publications, and (C) fit it to a pair of short articles. Hence, I must resort to brief answers; if something remains unclear – give us a call. This is part 1 of 2, about the AD&Co interest rate library.

Q. AD&Co has developed an “interest rate library.” What does it do?
A. It does two main things: (1) generate random or quasi-random rate paths for several user-defined maturity tenors; (2) it can price derivatives and path-independent instruments backwards. In either case, operations are performed on a lattice that is calibrated to market rates and volatilities.

While AD&Co’s interest rate library underpins our OAS system, it can also be integrated into a client’s application on its own. The library is built around the concept of risk-neutrality and is not intended for econometric rate forecasting.

Q. In 2002, AD&Co recommended using the Hull-White model instead of the Black-Karasinski model. Is this recommendation still valid?
A. Yes, it is. In 2004, the market evidence was revisited and confirmed. The Journal of Portfolio Management Winter 2004 paper was written based on the AD&Co 2002 Quantitative Perspectives, but with extended observations. I also included the dynamics of volatility indices as additional evidence.

AD&Co observes normality of rates and recommends using a normal model; such a model may have one or more factors.

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