FINANCIAL SYSTEMS DEVELOPMENT

Abstract

In the first part of this report, we explore three different techniques to price an exotic long short basket option, namely, exchange option, moment matching method and Bachelier model. After some justification, we choose the Bachelier model. Next, we provide a brief summary of the Stochastic Alpha, Beta and Rho (SABR) model, which is used to model the smile/smirk seen in market volatilities for options with different strike prices or maturities. We also summarize the correction to the original SABR model because the latter model has some inconsistency and pricing problems in the low strike region.