Re: LMM and finite difference methods

Posted by Joseph Wang on Nov 15, 2005; 7:19am
URL: http://quantlib.414.s1.nabble.com/LMM-and-finite-difference-methods-tp4222p4228.html

One of the nice things about not being employed in QF is that you can
actually talk about what you are doing :-) :-) :-)

Right now, I've become interested in interest rate models because I
think the following algorithm is viable.....

1) Look at the prices of non-deliverable currency forwards for the RMB
in Singapore/Hong Kong
2) Use the interest rate parity formula to calculate the effective
interest rate
3) Look at the price of currency forwards in Shanghai
4) Use the difference to calculate a "convenience yield" which
quantifies the effect of capital controls

At this point you then have the information you need to calculate the
prices for any RMB derivative you want.  The important thing is that the
effective interest rate is appears to be a more or less a log normal
with a defined volatility which is *not* true for the quoted interest
rates (which follow a Poission process and are really hard to get into a
continuous model).  So one thing to do then is to look at the price of
non-deliverable swaps to see if they make sense that that involves
understanding  the LMM model.

Now that you have a currency forward model, you can create a whole new
set of derivatives that cater to the PRC domestic market (i.e. a
security that is linked to the NYSE Standard and Poor 500).  I call
these Chinese Overseas Linked Securities (COLS) and the hopefully the
effective result of this will be to diversify the content of PRC savings
so that it isn't all going to treasury bonds and mortgage backed
securities.  (Also, another idea is to use depository receipts to allow
PRC savers to invest in PRC companies that are listed in Hong Kong and
New York.  I call these DCDR domestic Chinese depository receipts).

The only difficulty now is to convince a headhunter or investment bank
to take me seriously :-) :-) :-)

It doesn't help that my cover letters sound like an investment scam.

---------

Dear Major Investment Bank,

My name is DR. JOSEPH WANG.  I have a DOCTORATE OF PHILOSOPHY in
THEORETICAL ASTROPHYSICS specializing in FINITE DIFFERENCE METHODS.  I
am currently working on the QUANTLIB software package.  I have recently
began developing quantitative models of Chinese Reminbi Currency
Forwards that I believe will create the basis for a market for
derivative securities worth $1,000,000,000,000 (ONE TRILLION DOLLARS),
which will allow domestic savers in China access overseas markets
despite CAPITAL CONTROLS.  Let me assure you that what I am proposing is
PERFECTLY LEGAL, and that the proper bureaucratic approvals for these
DERVIATIVE SECURITIES will be received.  Let me also assure you that I
am an HONEST MAN, and that I intend to consider the possibility of
SYSTEMATIC INSTABILITY in the capital markets due to our efforts.

Unfortunately because of the difficulties in DEVELOPING and LISTING new
derivative securities in the People's Republic of China, I am unable to
access these funds, and I require the assistance of a MAJOR INVESTMENT
BANK, doing business or planning to do business in China with access to
RENMINBI.  I propose a situation that will be advantageous to both of
us.  When you issue these derivative securities that you can recoup some
of your effect by charging underwriting and commission fees.  In return,
I ask only that you provide me a small fraction of said fees as salary
for my services as a  QUANTITATIVE ANALYST.  As an immediate sign of
your GOOD FAITH, I request that you send me an AIRLINE ticket and
LODGING so that I may visit your CORPORATE HEADQUARTERS so that we may
discuss the terms of our arrangement.

Your UTMOST CONFIDENTIALITY and DISCRETION in this matter is appreciated.

Sincerely,

DR. JOSEPH WANG