Let’s pretend I am a trader on a structured products desk in late 2008, early 2009 and I have a very strong view that the baby has been thrown out with the bathwater, and numerous bonds that are currently priced at a deep discount will pay off at par. The catch is that between now and then the price on those bonds will vary dramatically, potentially causing unsustainable losses.
How much should I invest?
For make this problem initially more tractable, I’m going to assume:
- that we are working with equities so I can just model the underlying asset process with GBM and not worry about an interest rate model for now
- For the range of prices I will start at 20 and goto 100, and that the final asset price will be 100
The main reason I’m working on this is that it gives me a chance to play with Brownian Bridges, something I have not done before.