This paper considers the valuation of European style derivatives with payoffs depending on both a stock index and underlying LIBOR rates. The model has the attractive feature that it is based on observable market quantities which makes it very easy to calibrate. A closed form solution is derived for the price of the correlation derivative known as the traffic light option under lognormality assumptions for the underlying processes. A pricing approach for more general payoffs is presented, and an illustration is performed with Monte Carlo simulation by the pricing of a specific hybrid derivative with payoff depending on the performance of a stock index and the spread between two LIBOR rates. Further, it is briefly described how the traffic light option can be used for hedging interest rate risk and stock price risk.
Main Research Area:
The 20th Australasian Finance and Banking Conference, 2007