Chapter 26

Exotic Swap and Options Structures

A difference of opinion makes a market, and that is the major rationale for the development of the market in exotic swaps and exotic options. A second and less happy rationale is the willingness of some market participants to buy and sell securities without much knowledge of their true value. This is particularly dangerous in markets such as the LIBOR market (in which manipulation has been admitted) and the credit default swap market (in which manipulation is suspected and investigations are under way).

In our quest for an integrated measure of interest rate risk and credit risk, we need to handle these exotic structures because they are found on the balance sheet of many institutions both on the buy side and the sell side. Furthermore, two of the authors are ex-investment bankers. For that reason, we recognize the endless quest of investment bankers to invent structures that they can value more accurately than their clients. The collateralized debt obligation market, which we discussed in Chapter 20, is a classic example. The real purpose of this chapter is not only to value specific structures but to show that this approach is general enough to apply to new structures as they emerge. That reflects the great power of the Heath, Jarrow, and Morton (HJM) framework that we demonstrated in increasingly realistic worked examples in Chapters 6 through 9. In this chapter, we again employ the three-factor HJM example from Chapter 9.

In the ...

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