Research Of Pricing Options Embedded In Deposits And Loans Using Monte Carlo Simulation

In recent years , with the opening up of China's financial markets and the continuing process of Market-oriented interest rate , the fluctuation of interest rate becomes more and more frequent and intensive , and this have brought new opportunities and challengs to the commercial bank of China : The frequent fluctuations in interest rate also will make banks to face greater option risk . Traditional duration and convexity gap management not only fail to manage the interest rate risk of embedded option in deposits and loans effectively, it will lead the risk managers to ignore its existence. Therefore , study the pricing techniques of embedded options in financial institutions's deposits , loans and other assets , has important theoretical and practical significance both to the development of new financial product and risk management . While the embedded option is complex and multi-dimensional , using numerical analysis method for option pricing has become an essential tool.Existing banks ignore the potential risks of the treaty in deposits and loans which can be performed ahead of time , while this paper makes deep study of the factors of options embedded in deposits and loans under the Market-oriented interest rate conditions , and using statistical methods and Monte Carlo simulation techniques to analyze the pricing methods for this type of option and the techniques of variance reductiion .Firstly , we analyze the natures , features , and the border of implementation of the embedded options , from the investment behavior of the depositors and borrowers'view , and arrive at the conclusion that such embedded option is an American-type which based on the change of interest rate ; at the same time , Lin and Zheng (2004) based on the analysis of pricing embedded options , summarized the shortcoming of traditional methods for pricing complex derivatives .Secondly , on the basis of the characteristic of embedded options , in this paper we make analysis of the characteristic of interest rate—which is the subject of embedded options , and find that the Jump-Diffusion interest rate model is more fit to describe Chinese market ; at the same time , we comprehensively use econometrics method , statistical analysis and random process analysis to estimate the parameters of Jump-Diffusion model , and make comparision of the errors between the diffusion interest rate model without jump and with jumps . From the comparison , we get that the Jump-diffusion interest rate is more fit for the real data , and it is more reasonable for pricing rate-derivatives.Thirdly , we make research on Monte Carlo Simulation for the pricing interest rate derivatives , combining the characteristic of options embedded in the deposits and loans , and the best strategy for the implementation of the investors , and take the five-years deposits and ten-years loans for examples , the results show that :In all the business of the banks'deposits and loans , the banks ignore the value of the options embedded in them , if we can take charge of the embedded options , the liquidity risk will be reduced strongly , and can reduce its financial exposure . While the value of option embedded in five-years deposits is 0.0015 , the value of option embedded in ten-years loans is 0.0028 . That is to say , we should reduce corresponding value of option in the deposits business , and to add the corresponding value of option in the loans business , that is more conservative and reasonable interest rate .Finally , for the shortcomings of the Monte Carlo Simulation , we optimize it with Antithetic Variate technique and Control Variate technique , and make analysis of principle and the process , then we take the five-years deposits and ten-years loans as examples , using the optimized Monte Carlo simulation for pricing . The result shows that , Monte Carlo Simulation can be used for pricing the interest rate option embedded in deposits and loans , and the optimized Monte carlo Simulation is more fittable .Through the study of literature at home and abroad , and the empirical research and simulations , this paper comes to the follow conclusions : First , with the process of interest rate reform , the rate option risk of the banks has become a risk that should not be ignored ; Second , the Jump-Diffusion interest rate model can be more fit to describe the rate behavior , and with more accuracy ; Third , through the Monte Carlo Simulation and the introducing of variance reduction technique , we get the price of the options embedded in the deposits and loans , and find that the re-simulation control variate technique will obtain the lest variance and volatility .