Default Dependency Impact

The detailed assessment of the model framework (e.g., examination of the model’s quantitative and qualitative components including numerical techniques and approximations and validate whether methodology is appropriate for the intended purpose and is mathematically correct etc) is summarized.

There is no arbitrage, which makes it possible to state the price of an asset in terms of risk-neutral probabilities, where the discounting is done at the risk-free rate. This assumption is very commonly used and universally accepted in both industry and academic world.

Lognormal random walk of the underlying price in all option valuations. This assumption is commonly accepted in the industry.

With the exception of option-embedded bonds, interest rates are deterministic. Considering these valuations are just for risk management purposes, this assumption is reasonable to achieve a balance between computational efficiency and accuracy. In addition, it is commonly accepted in the industry.

The recovery rate is constant, and may not reflect the true amount that would be received if a default were to occur. The tax rate for interest income is zero

For floating rate notes (FRN), the coupon payment interval is the same as the reference tenor. This is the usual case. If the reference rate tenor differs from the payment interval, for example, the reference rate is the LIBOR 6 month rate while the coupon is paid quarterly, the pricing formula only approximates the theoretical value due to the lack of timing and convexity adjustment.

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