Market Consistency Model Calibration in Imperfect Markets

by Kemp, Malcolm

• ISBN13: 9780470770887
• ISBN10: 0470770880
• Edition: 1st
• Format: Hardcover
• Copyright: 2009-10-12
• Publisher: Wiley

Summary

A core tenet of modern finance (and of modern financial regulation) is the need, in many circumstances, to mark positions to market, i.e. to calibrate position valuations to be in line with observed market prices. This focus on market consistency is also a key theme for risk managers, fund managers and traders who wish to place appropriate weight on the views of other market participants.Despite its fundamental importance, achieving market consistency can be challenging even for established professionals. Not all instruments are actively traded, and even when they are they may trade with wide or variable bid-ask spreads. Interpolating or extrapolating from what is actually observable in the market place to what is needed to make the most of market consistent perspectives can tax even experts.In this book, the author carefully explains in a logical sequence when and how market consistency should be used, what it means for different financial disciplines and how it can be achieved for both liquid and less liquid positions. The author also explains why market consistency is intrinsically difficult to achieve with certainty in some types of activities, including computation of hedging parameters, and provides solutions to even the most complex problems. The focus is very much on blending mathematical rigour with practical insight, drawing upon the author's wide practical experience across the spectrum of quantitative finance.

Author Biography

Malcolm Kemp is a well known actuary and expert in risk and quantitative finance, with over 25 years’ experience in the financial services industry. From 1996 to 2009 he was Head of Quantitative Research at a leading UK investment management business and before that was a partner in an actuarial consultancy. He is currently Managing Director of Nematrian Limited.

Table of Contents

Preface

Acknowledgements

Abbreviations

Notation

Introduction

Market consistency

The primacy of the æmarket

Calibrating to the æmarketÆ

Structure of book

Terminology

When is and when isnÆt market consistency appropriate?

Introduction

Drawing lessons from the characteristics of money itself

Regulatory drivers favouring market consistent valuations

Underlying theoretical attractions of market consistent valuations

Reasons why some people reject market consistency

Market making versus position-taking

Contracts that include discretionary elements

Valuation and regulation

Marking-to-market versus marking-to-model

Rational behaviour?

Different meanings given to æmarket consistent valuationsÆ

Introduction

The underlying purpose of a valuation

The importance of the æmarginalÆ trade

Different definitions used by different standards setters

Interpretations used by other commentators

Derivative pricing theory

Introduction

The principle of no arbitrage

Lattices, martingales and Îto calculus

Calibration of pricing algorithms

Jumps, stochastic volatility and market frictions

Equity, commodity and currency derivatives

Interest rate derivatives

Credit derivatives

Volatility derivatives

Hybrid instruments

Monte Carlo techniques

Weighted Monte Carlo and analytical analogues

Further comments on calibration

The risk-free rate

Introduction

5.2 What do we mean by ærisk-freeÆ?

Choosing between possible meanings of ærisk-freeÆ

Liquidity theory

Introduction

Market experience

Lessons to draw from market experience

General principles

Exactly what is liquidity?

Liquidity of pooled funds

Risk measurement theory&

Introduction

Instrument-specific risk measures

Portfolio risk measures

Time series based risk models

Inherent data limitations applicable to time series based risk models

Credit risk modelling

Risk attribution

Stress testing

Capital adequacy

Introduction

Financial stability

Banking

Insurance

Pension funds

Different types of capital

Calibrating risk statistics to perceived æreal worldÆ distributions

Introduction

Referring to market values

Backtesting

Fitting observed distributional forms

Fat-tailed behaviour in individual return series

Fat-tailed behaviour in multiple return series

Calibrating risk statistics to æmarket impliedÆ distributions

Introduction

Market implied risk modelling

Fully market consistent risk measurement in practice

Avoiding undue pro-cyclicality in regulatory frameworks

Introduction

The 2007-09 credit crisis

Underwriting of failures

Possible pro-cyclicality in regulatory frameworks

Re-expressing capital adequacy in a market consistent framework

Discount rates

Pro-cyclicality in Solvency II

Systemic impacts of pension fund valuations

Sovereign default risk

Portfolio construction

Introduction

Risk-return optimisation

Other portfolio construction styles

Risk budgeting

Reverse optimisation and implied view analysis

Calibrating portfolio construction techniques to the market

Catering better for non-Normality in return distributions

Robust optimisation

Taking due account other investorsÆ risk preferences

Calibrating valuations to the market

Introduction

Price formation and price discovery

Market consistent asset valuations

Market consistent liability valuations

Market consistent embedded values

Solvency add-ons

Defined benefit pension liabilities

Unit pricing

The final word

Bibliography

Index

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