Impact of latent variables in option trading on GILT segment (A working Paper)
GILT as a segment (especially the 10 Year one) is always a coveted one for all types of treasury related activities, across countries. GILT is traditionally purchased and traded either as future segment or in cash segment. Traditionally in India GILT trading happens more on the futures route. Ideally this depends upon the number of contracts on offer and open interest generated among traders from various treasuries. Trading in GILT Options predominantly happens in Banks, and it’s both calculations as well as perception based. If post opting for a certain option the caller backs out, then he has to pay the necessary premium as a cost. Most of the time either the Options in GILT segment do not gets exercised.
The most apt paper in this domain was written by Jayant Verma (1996) in IJAF. This paper has argued that the most practical and sensible way of valuing interest rate options in India is to use a single factor lattice based model. Single factor models (which are based on the short term interest rate) are to be preferred not only for their greater simplicity, but also because multi-factor models would require knowledge of the dynamics of long term rates which is not available in India at present. Within the class of single factor lattice based models, the Black-Derman-Toy model emerged as the most serious contender because its assumptions are