Procedure

Create the following hierarchy to display a forward volatility agreement as a generic transaction: The options included in the forward volatility agreement are not explicitly specified. You can find information about options in the top node, which has the transaction form 65 (forward volatility agreement). The node at the next level down in the hierarchy has the transaction form 41 (foreign exchange transaction), and contains the foreign currency cash flow, specifying the underlying of the option.

Create the hierarchy as follows:

Create a new generic transaction. See Edit Generic Transaction for the procedure.

In the dialog structure, select the first elementary transaction and assign to it transaction form 065 (forward volatility agreement).

The system displays three tab pages.

Enter the following information on the Header Information tab page:

Start of term field.

Option start date (this is the same as the end date of the forward transaction)

The system uses the date you created the forward volatility agreement on as the start date for the forward transaction.

End of term field.

End date of option

Purchase/Sale field

Specify whether the forward volatility agreement is a purchase or a sale.

( )

The system interprets the forward volatility agreement as a purchase or a sale depending on the entries you make for the elementary transaction at the top of the hierarchy.

The Cash Flow tab page is not relevant to valuating the forward volatility agreement.

Only the following fields on the Option Information tab page are relevant:

Strike Currency field

Transaction currency

Forward Volatility field

Specify the agreed forward volatility. You specify this for the year, even if the volatility relates to the term of the option.

( )

The Exercise Type field is not relevant here because the price calculator is presently only able to valuate forward volatility agreements with a European type of exercise. The Put/Call indicator remains empty (in a forward volatility agreement, the put and call options are the same.)

Create a transaction with the transaction form 41 (foreign exchange) under the Forward Volatility Agreement elementary transaction for the first elementary transaction at the second, lower level in the hierarchy. To do this, select the Forward Volatility Agreement elementary transaction in the dialog structure and choose ( ) Create Elementary Trans.: Next Level .

Select the new elementary transaction and assign to it transaction form 41.

The system then displays three tab pages. Only the Cash Flow tab page is relevant. Enter the following information:

Due Date field

Date on which the payment is made.

Cash Flow Amount and Currency fields

Nominal value of the forward volatility agreements

Choose ( ) Back and then ( ) Save .

Result

You have created the forward volatility agreement as a generic transaction.

Example

A bank negotiates a forward volatility agreement to hedge against changes to the volatility of the euro/US dollar exchange rate. The underlying straddle is to be exchanged on January 12 2004. The due date for the option has been agreed on as February 12 2004. The underlying for the options is a cash flow of 1.2 million US dollars that is to be paid on the option due date.

To create the forward volatility agreement, you need the yearly forward volatility σ forward of the euro/US dollar exchange rate for the straddle period. For example, if we take a transaction that was concluded on 12.12.2003, at that time, for the period t 1 of a month, we would have the volatility σ 1 11.64, and for the period t 2 of two months, the volatility σ 2 10.90.

The following formulas apply to forward volatilities for volatility values that have already been annualized:

Because the price calculator does not evaluate them, the Option Category , Exercise Type , and Put/Call Indicator fields on the Option Information tab page can remain empty.

The Direction field on the Cash Flow tab page can stay empty because the price calculator does not evaluate this area.