YR Into Duct Ion Finance Quantitative

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Quantitative Finance and its connection with Probability

. Yves Rakotondratsimba
ECE Paris, graduate school of engineering 37 quai de Grenelle CS71520 75 725 Paris cedex15, France w_yrakoto@yahoo.com
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26 septembre 2011
Yves Rakotondratsimba ( ECE Paris, graduate school of engineeringits connection with Probability 75 7252011 cedex15, Fra Quantitative Finance and 37 quai de Grenelle CS71520 26 septembre Paris 1 / 22
Outline
. 1 . . The current market activities Main changes on interest rates markets Main concerns with counterparty risks . 2 . . Stochastic calculus and its link on derivative products . 3 . . Main role of modeling in derivative deals
The current market activities
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Following the 2007-2008 nancial crisis, there were criticism from governments, press and so on against mathematics, CDSs and CDOs.
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Following the 2007-2008 nancial crisis, there were criticism from governments, press and so on against mathematics, CDSs and CDOs. The criticism is focused on the use of mathematics for credit risk and valuation of CDOs. Quants have been blamed for blindly believing ungranted assumptions, not being aware of the model limitations and providing the market with a false sense of security. Mathematics is accused at the same time of being obscurely sophisticated and naively simplistic.
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Following the 2007-2008 nancial crisis, there were criticism from governments, press and so on against mathematics, CDSs and CDOs. The criticism is focused on the use of mathematics for credit risk and valuation of CDOs. Quants have been blamed for blindly believing ungranted assumptions, not being aware of the model limitations and providing the market with a false sense of security. Mathematics is accused at the same time of being obscurely sophisticated and naively simplistic. Really quants were aware of limitations and have been proposing improved methodology before and across the crisis.
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Alternative models have since then emerged. However they have not been developed and tested enough to become operational on a trading oor or in large risk platform. Changing the model implies a long path involving a number of issues that have little to do with modeling and more to do with IT problems ( integration with other systems ). Also there is the self-fullling prophecy that if everyone uses or believes in a wrong model. In clear the inertia seems to be persistent.
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Alternative models have since then emerged. However they have not been developed and tested enough to become operational on a trading oor or in large risk platform. Changing the model implies a long path involving a number of issues that have little to do with modeling and more to do with IT problems ( integration with other systems ). Also there is the self-fullling prophecy that if everyone uses or believes in a wrong model. In clear the inertia seems to be persistent. The market has been using simplistic approaches ( think to the Black-Scholes option pricing ) but it is has also been trying to move beyond these ( think to the Variance-Gamma option pricing introduced now on the Bloomberg platform ).
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Alternative models have since then emerged. However they have not been developed and tested enough to become operational on a trading oor or in large risk platform. Changing the model implies a long path involving a number of issues that have little to do with modeling and more to do with IT problems ( integration with other systems ). Also there is the self-fullling prophecy that if everyone uses or believes in a wrong model. In clear the inertia seems to be persistent. The market has been using simplistic approaches ( think to the Black-Scholes option pricing ) but it is has also been trying to move beyond these ( think to the Variance-Gamma option pricing introduced now on the Bloomberg platform ).
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We have to put always in mind that models obey a simple rule that is popularly summarized by the acronym GIGO ( Garbage IN, Garbage . . . . . . OUT ). Yves Rakotondratsimba ( ECE Paris, graduate school of engineeringits connection with Probability 75 7252011 cedex15, Fra Quantitative Finance and 37 quai de Grenelle CS71520 26 septembre Paris 4 / 22
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Main changes on interest rates markets
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The nancial crisis started on August 2007 has been triggered now a deep and pervasive consequences on the market.
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The nancial crisis started on August 2007 has been triggered now a deep and pervasive consequences on the market. The interbank market now quotes much higher and dierentiated credit and liquidity premia. Even plain vanilla quotes have drastically changed. The new business of liquidity trading has emerged.
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The nancial crisis started on August 2007 has been triggered now a deep and pervasive consequences on the market. The interbank market now quotes much higher and dierentiated credit and liquidity premia. Even plain vanilla quotes have drastically changed. The new business of liquidity trading has emerged. As a consequence the classical theoretical framework based on a single risk free curve and arbitrage relations must be abandoned in favor of a new framework. It appears the need to review the no-arbitrage models used for pricing and risk analysis, and then to include a coherent pricing of liquidity and counterparty risk.
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The nancial crisis started on August 2007 has been triggered now a deep and pervasive consequences on the market. The interbank market now quotes much higher and dierentiated credit and liquidity premia. Even plain vanilla quotes have drastically changed. The new business of liquidity trading has emerged. As a consequence the classical theoretical framework based on a single risk free curve and arbitrage relations must be abandoned in favor of a new framework. It appears the need to review the no-arbitrage models used for pricing and risk analysis, and then to include a coherent pricing of liquidity and counterparty risk. As a consequence the nancial libraries and pricing systems implementation and usage must be carefully reviewed and re-engineered.
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The liquidity and collateral management must integrate coherently the cost of funding generated by derivatives and CSA (Credit Support Annex), thus inducing transfer of business among dierent areas inside banks.
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The liquidity and collateral management must integrate coherently the cost of funding generated by derivatives and CSA (Credit Support Annex), thus inducing transfer of business among dierent areas inside banks. The ALM (Asset Liability Management) must take into account the basis risk in hedge accounting. The accounting, advisory and regulatory sides must evolve to take into account that the fair value of derivatives is CSA dependent. The management must lead the change and the corresponding frictions, taking business opportunities and controlling risks.
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The liquidity and collateral management must integrate coherently the cost of funding generated by derivatives and CSA (Credit Support Annex), thus inducing transfer of business among dierent areas inside banks. The ALM (Asset Liability Management) must take into account the basis risk in hedge accounting. The accounting, advisory and regulatory sides must evolve to take into account that the fair value of derivatives is CSA dependent. The management must lead the change and the corresponding frictions, taking business opportunities and controlling risks. The basic interest rates used in the market are the following
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LIBOR ( London InterBank Oered Rate ) EURIBOR ( Euro InterBank Oered Rate ), EONIA ( Euro OverNight Index Average ) EUREPO ( Euro Repurchase Agreement Rate ). .
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When used as collateral the LIBOR, EURIBOR and EONIA should be viewed as unsecured. Moreover both the LIBOR and EURIBOR entail counterparty and Liquidity risks. These risks are low for the EONIA and negligible for the EUREPO.
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When used as collateral the LIBOR, EURIBOR and EONIA should be viewed as unsecured. Moreover both the LIBOR and EURIBOR entail counterparty and Liquidity risks. These risks are low for the EONIA and negligible for the EUREPO. After the credit crunch, the following stylized facts has been observed in the market :
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divergence between deposit ( Libor based ) and OIS ( Overnight Index Swap ) ; divergence between FRA rates and the corresponding forward rates imples by consecutive deposits ; explosion of basis swap rates ( based on Libor rates with dierent tenors ) ; shift from unsecured towards secured market instruments ; shift towards CSA discounting, for collateralized cashows : ICAP, Swapclear.
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Similar interest rate instruments with dierent underlying rate tenors are seen in practice by dierent liquidity and credit risk premia reecting dierent views and interests of the market players.
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Similar interest rate instruments with dierent underlying rate tenors are seen in practice by dierent liquidity and credit risk premia reecting dierent views and interests of the market players. The credit crunch has acted as a sort of symmetry breaking mechanism. Indeed from a situation in which an unique short rate process was able to model and explain the whole term structure of interest rates of all tenors, we observe in reality a sort of market segmentation into sub-areas corresponding to instruments with dierent underlying rate tenors characterized in principle by distinct dynamics, i.e. dierent short rate processes.
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Similar interest rate instruments with dierent underlying rate tenors are seen in practice by dierent liquidity and credit risk premia reecting dierent views and interests of the market players. The credit crunch has acted as a sort of symmetry breaking mechanism. Indeed from a situation in which an unique short rate process was able to model and explain the whole term structure of interest rates of all tenors, we observe in reality a sort of market segmentation into sub-areas corresponding to instruments with dierent underlying rate tenors characterized in principle by distinct dynamics, i.e. dierent short rate processes. The market segmentation was already present and well understood before the credit crunch but it is not eective due to negligible basis spread.
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In regulated markets, the settlement and margination are done in daily basis. Moreover the collateral cash are made by main currencies or highly rated bonds. In contrast in the OTC markets most contracts are negotiated under the ISDA Master Agreement or the CSA ( Credit Support Annex ). Collateral used depends on the agreements.
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In regulated markets, the settlement and margination are done in daily basis. Moreover the collateral cash are made by main currencies or highly rated bonds. In contrast in the OTC markets most contracts are negotiated under the ISDA Master Agreement or the CSA ( Credit Support Annex ). Collateral used depends on the agreements. The ISDA master agreement is the most commonly used master contract for OTC derivative transactions internationally. It is part of a framework of documents, designed to enable OTC derivatives to be documented fully and exibly. The framework consists of a master agreement, a schedule, conrmations, denition booklets, and a credit support annex. The ISDA master agreement is published by the International Swaps and Derivatives Association.
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The master agreement is a document agreed between two parties that sets out standard terms that apply to all the transactions entered into between those parties. Each time that a transaction is entered into, the terms of the master agreement do not need to be re-negotiated and apply automatically. Although it is often viewed as a tool for banks and nancial institutions, the Master Agreement is widely used by a wide variety of counterparties.
Yves Rakotondratsimba ( ECE Paris, graduate school of engineeringits connection with Probability 75 725 Paris cedex15, Fra Quantitative Finance and 37 quai de Grenelle CS71520 26 septembre 2011 10 / 22
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The master agreement is a document agreed between two parties that sets out standard terms that apply to all the transactions entered into between those parties. Each time that a transaction is entered into, the terms of the master agreement do not need to be re-negotiated and apply automatically. Although it is often viewed as a tool for banks and nancial institutions, the Master Agreement is widely used by a wide variety of counterparties. A Credit Support Annex, or CSA, is a legal document which regulates credit support (collateral) for derivative transactions. It is one of the four parts that make up an ISDA Master Agreement but is not mandatory. It is possible to have an ISDA agreement without a CSA but normally not a CSA without an ISDA. A CSA denes the terms or rules under which collateral is posted or transferred between swap counterparties to mitigate the credit risk arising from in the money derivative positions. . . . . . .
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The master agreement is a document agreed between two parties that sets out standard terms that apply to all the transactions entered into between those parties. Each time that a transaction is entered into, the terms of the master agreement do not need to be re-negotiated and apply automatically. Although it is often viewed as a tool for banks and nancial institutions, the Master Agreement is widely used by a wide variety of counterparties. A Credit Support Annex, or CSA, is a legal document which regulates credit support (collateral) for derivative transactions. It is one of the four parts that make up an ISDA Master Agreement but is not mandatory. It is possible to have an ISDA agreement without a CSA but normally not a CSA without an ISDA. A CSA denes the terms or rules under which collateral is posted or transferred between swap counterparties to mitigate the credit risk arising from in the money derivative positions. . . . . . .
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Main concerns with counterparty risks
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The 2007 crisis has been the real driven for banks to handle Counterparty Credit Risk ( CCR ) more accurately since ! no counterparty even big can be assumed as risk-free ; credit risk was not perfectly tracked and evaluated when deeply embedded in some credit derivatives.
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The 2007 crisis has been the real driven for banks to handle Counterparty Credit Risk ( CCR ) more accurately since ! no counterparty even big can be assumed as risk-free ; credit risk was not perfectly tracked and evaluated when deeply embedded in some credit derivatives. A new respect for counterparty risk is reshaping the commercial landscape in the derivatives market. Growing numbers of banks are applying additional charges to their transactions, reecting the cost they would bear if a counterparty collapsed while owing them money. These charges are calculated and applied dierently from bank to bank, resulting in quotes that can vary by millions of dollars for the same transaction. Unsurprisingly, derivatives users are shopping around and, for many, price remains the most important criterion, meaning those with the most conservative credit pricing risk losing out.
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The principle of what banks call a Credit Valuation Adjustment ( CVA ) is fairly straightforward. The idea is that if there is a transaction where the client owes you 1 million and the client defaults, you would want to be able to replace the transaction, and the question is how much that would cost you. Essentially, you want to buy the option to enter into the same transaction on the same terms at the time the counterparty defaults and that is what you ask the customer to pay upfront.
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The principle of what banks call a Credit Valuation Adjustment ( CVA ) is fairly straightforward. The idea is that if there is a transaction where the client owes you 1 million and the client defaults, you would want to be able to replace the transaction, and the question is how much that would cost you. Essentially, you want to buy the option to enter into the same transaction on the same terms at the time the counterparty defaults and that is what you ask the customer to pay upfront. Banks approach the actual CVA calculation by estimating two things : the chances of a customer defaulting, and the size of the exposure at default. The probability of default is typically derived from spreads in the Credit Default Swap (CDS) market. Many banks then use the money raised by the credit charge to buy CDSs covering some or all the counterparty exposure, with the pricing and buying coverred and managed derivatives by making use of a centralised CVA desk. . . . . . .
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The market has denitely changed. Now everyone, every bank, wants to do the same. If you are a corporate client, whichever bank you go to is going to charge you for the counterparty risk.
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The market has denitely changed. Now everyone, every bank, wants to do the same. If you are a corporate client, whichever bank you go to is going to charge you for the counterparty risk. Equally, though, counterparties are under no obligation to trade with the bank oering a price that is technically the most accurate if another is oering a lower-cost transaction, so banks using a CVA approach may nd themselves losing business.
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The market has denitely changed. Now everyone, every bank, wants to do the same. If you are a corporate client, whichever bank you go to is going to charge you for the counterparty risk. Equally, though, counterparties are under no obligation to trade with the bank oering a price that is technically the most accurate if another is oering a lower-cost transaction, so banks using a CVA approach may nd themselves losing business. Pricing for counterparty risk is essential because collateral, a more widely used risk mitigant, has serious limitations. If each transaction, or portfolio of transactions, was covered by an agreement to adjust collateral in real time, it would be the ideal way of mitigating risk. But such an approach would be capital, intensive and require sophisticated back oces, which some hedge funds and most banks possess but other counterparties lack.
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Instead, most collateral agreements with nancial institutions calculate posting requirements on a daily basis, while corporate customers might post collateral against their positions only once a month. In both situations, sudden market movements can result in collateral being insucient to cover the position if the counterparty should default.
Stochastic calculus and its link on derivative products
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Derivatives are nancial instruments having cash ows depending on the value(s) of one or many underlying assets.
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Derivatives are nancial instruments having cash ows depending on the value(s) of one or many underlying assets. The underlying asset may be a basic instrument as a stock such that the corresponding derivative is named as equity option. A (stock) basket option arises when the underlying are made by various types of stocks.
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Derivatives are nancial instruments having cash ows depending on the value(s) of one or many underlying assets. The underlying asset may be a basic instrument as a stock such that the corresponding derivative is named as equity option. A (stock) basket option arises when the underlying are made by various types of stocks. When the underlying asset is made by one or more interest rate instrument ( as a coupon bearing bond ) then we are face with an interest rate derivatives.
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Derivatives are nancial instruments having cash ows depending on the value(s) of one or many underlying assets. The underlying asset may be a basic instrument as a stock such that the corresponding derivative is named as equity option. A (stock) basket option arises when the underlying are made by various types of stocks. When the underlying asset is made by one or more interest rate instrument ( as a coupon bearing bond ) then we are face with an interest rate derivatives. Therefore the underlying asset to a derivative product may be a nancial instrument as a derivative on something. In commodity markets, derivatives have very often physical underlying assets ( wheat, cocoa, cooper, silver, oil, gaz and so on ). . . . . . .
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Financial instruments and physical assets underlying to a derivative are very often tradable assets. But it may happen that people are concerned with derivatives lying on non-tradable assets as the weather, credit risks, market fears ( volatility, liquidity, herd-behavior . . . ).
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Financial instruments and physical assets underlying to a derivative are very often tradable assets. But it may happen that people are concerned with derivatives lying on non-tradable assets as the weather, credit risks, market fears ( volatility, liquidity, herd-behavior . . . ). As the nancial engineers have unlimited imaginations, there are consequently unbounded types of derivatives of nancial types ( as equity option ) or not ( as real option ). It is important to note that all derivatives are introduced in order to satisfy special requirements coming from the market participants. Each counterparty entering in a derivative deal expects to get satisfactions.
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Financial instruments and physical assets underlying to a derivative are very often tradable assets. But it may happen that people are concerned with derivatives lying on non-tradable assets as the weather, credit risks, market fears ( volatility, liquidity, herd-behavior . . . ). As the nancial engineers have unlimited imaginations, there are consequently unbounded types of derivatives of nancial types ( as equity option ) or not ( as real option ). It is important to note that all derivatives are introduced in order to satisfy special requirements coming from the market participants. Each counterparty entering in a derivative deal expects to get satisfactions. In the engineering and trading sides, each derivative contract should clearly describe the associated pay-o and the commitment for all counterparties involved in the deal.
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The pay-o is always described in term of event and its monetary equivalent. Each event is linked to one or more uncertain and temporal variable(s) which can be considered, for the quantitative nance point of view, as given by some stochastic processes.
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The pay-o is always described in term of event and its monetary equivalent. Each event is linked to one or more uncertain and temporal variable(s) which can be considered, for the quantitative nance point of view, as given by some stochastic processes. Therefore the pay-o linked to a derivative instrument can be seen as a simple or complicated function having one or more variable(s) as stochastic processes.
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The pay-o is always described in term of event and its monetary equivalent. Each event is linked to one or more uncertain and temporal variable(s) which can be considered, for the quantitative nance point of view, as given by some stochastic processes. Therefore the pay-o linked to a derivative instrument can be seen as a simple or complicated function having one or more variable(s) as stochastic processes. Stochastic calculus should be viewed as the analogue of the standard calculus with the dierence that the variables under consideration in stochastic calculus are stochastic processes.
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The pay-o is always described in term of event and its monetary equivalent. Each event is linked to one or more uncertain and temporal variable(s) which can be considered, for the quantitative nance point of view, as given by some stochastic processes. Therefore the pay-o linked to a derivative instrument can be seen as a simple or complicated function having one or more variable(s) as stochastic processes. Stochastic calculus should be viewed as the analogue of the standard calculus with the dierence that the variables under consideration in stochastic calculus are stochastic processes. A stochastic process may be seen as a real or vectorial function having the time and the uncertainty as variables. Equivalently it is a random . . . . . . variable depending on time evolution.
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Rules on standard function calculus do not hold for stochastic processes. For instance the derivative of a function having a stochastic process requires a special feature usually referred as the It lemma.
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Rules on standard function calculus do not hold for stochastic processes. For instance the derivative of a function having a stochastic process requires a special feature usually referred as the It lemma.
Main role of modeling in derivative deals
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As recalled above, the pay-o linked to a derivative may be seen as an explicit function of one or more stochastic processes assumed to theoretically represent the value of the underlying asset .
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As recalled above, the pay-o linked to a derivative may be seen as an explicit function of one or more stochastic processes assumed to theoretically represent the value of the underlying asset . To value, measure the associated risks, and manage a given derivative product, it is important to introduce models for the underlying asset.
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As recalled above, the pay-o linked to a derivative may be seen as an explicit function of one or more stochastic processes assumed to theoretically represent the value of the underlying asset . To value, measure the associated risks, and manage a given derivative product, it is important to introduce models for the underlying asset. It should be emphasized that a model is just an imperfect representation of the reality. For a given economic or nancial variable, the quant modeler may have various possible candidate models. Her nal choice has to make some compromise between the reality representation and the model tractability.
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The nancial model for a given economic or nancial variable is assumed to summarize the corresponding behavior of some variable inside a considered framework and may also make use of one or many probabilistic model(s). For instance a model for the price of a stock should make use of a nonnegative quantity where the economical facts as the tendency and volatility must appear. Moreover the uctuation of the price around its tendency is translated by the use of a brownian motion, which may seen as a centered gaussian variable scaled by the time.
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The nancial model for a given economic or nancial variable is assumed to summarize the corresponding behavior of some variable inside a considered framework and may also make use of one or many probabilistic model(s). For instance a model for the price of a stock should make use of a nonnegative quantity where the economical facts as the tendency and volatility must appear. Moreover the uctuation of the price around its tendency is translated by the use of a brownian motion, which may seen as a centered gaussian variable scaled by the time. To build models is not an easy task. It means the ability to synthesize physic realities into formulas, to be familiarized with probabilistic models, to be able to deal with computing.
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Though modeling is for high level quants, once a model is built and has received a consensus among the academic and industrial nance, then a large part of market participants, especially those who are involved with selling and managing nancial derivative products should at least be able to understand and cope with the well-established model for the considered derivative.
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Though modeling is for high level quants, once a model is built and has received a consensus among the academic and industrial nance, then a large part of market participants, especially those who are involved with selling and managing nancial derivative products should at least be able to understand and cope with the well-established model for the considered derivative. Traders, sellers and risk controllers on derivatives should understand well the pay-o expressions of the options they are involved on, and are able to grasp the implementation of the model used for the considered nancial product.
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Though modeling is for high level quants, once a model is built and has received a consensus among the academic and industrial nance, then a large part of market participants, especially those who are involved with selling and managing nancial derivative products should at least be able to understand and cope with the well-established model for the considered derivative. Traders, sellers and risk controllers on derivatives should understand well the pay-o expressions of the options they are involved on, and are able to grasp the implementation of the model used for the considered nancial product. The model, used for the underlying asset(s), enables the user to obtain well-founded scenarios for the pay-o behavior at the maturity or during the life of the considered derivative instrument. So simulation of possible realizations of the pay-o may be obtained from the model.
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Understanding the foundation of stochastic processes and the associated calculus rule may be a challenge for any one with less quantitative education. In contrast, the mechanism underlying the simulation of the behavior of these processes ( which is important for the practitioner viewpoint ) is more and less easy to perform.

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Quantitative Finance and its connection with Probability

The current market activities

The current market activities

The current market activities

The current market activities

The current market activities

The current market activities

The current market activities

The current market activities

The current market activities

The current market activities

The current market activities

The current market activities

The current market activities

Main changes on interest rates markets

Main changes on interest rates markets

The current market activities

Main changes on interest rates markets

Main changes on interest rates markets

The current market activities

Main changes on interest rates markets

Main changes on interest rates markets

The current market activities

Main changes on interest rates markets

Main changes on interest rates markets

The current market activities

Main changes on interest rates markets

Main changes on interest rates markets

The current market activities

Main changes on interest rates markets

Main changes on interest rates markets

The current market activities

Main changes on interest rates markets

Main changes on interest rates markets

..1. ..2. ..3. ..4.

The current market activities

Main changes on interest rates markets

Main changes on interest rates markets

The current market activities

Main changes on interest rates markets

Main changes on interest rates markets

..1. ..2. ..3. ..4. ..5.

The current market activities

Main changes on interest rates markets

Main changes on interest rates markets

The current market activities

Main changes on interest rates markets

Main changes on interest rates markets

The current market activities

Main changes on interest rates markets

Main changes on interest rates markets

The current market activities

Main changes on interest rates markets

Main changes on interest rates markets

The current market activities

Main changes on interest rates markets

Main changes on interest rates markets

The current market activities

Main changes on interest rates markets

Main changes on interest rates markets

The current market activities

Main changes on interest rates markets