Lecture_18 - 18 Extensions A major advantage of the term...

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1 18 Extensions A major advantage of the term structure model presented in this textbook is that it is easily extended to incorporate additional term structures. The introduction of additional term structures is the generalization needed to price and hedge foreign-currency derivatives, credit derivatives, and commodity options.
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2 A Foreign-Currency Derivatives To price and hedge foreign-currency derivatives, one needs a spot exchange rate of foreign into domestic currency and two zero-coupon bond price curves: (i) one for the domestic currency and (ii) one for the foreign currency. The method for building an arbitrage-free evolution of these term structures proceeds in a fashion identical to that given in Chapters 3-9. The only complication is that in constructing the tree, two price vectors are included at each node.
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3 One vector is for the domestic currency zero-coupon curve (just as before), and one vector is for the foreign currency zero-coupon curve with the spot exchange rate appended. The arbitrage-free conditions correspond to the existence of pseudo probabilities, which make all dollar-denominated and dollar- translated securities (foreign zero-coupon bonds) martingales after
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Lecture_18 - 18 Extensions A major advantage of the term...

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