Market Consistency : Model Calibration in Imperfect Markets

by Malcolm Kemp (London, UK)

• ISBN13: 9780470684887
• ISBN10: 0470684887
• Format: eBook
• Copyright: 2009-09-01
• Publisher: Wiley

Summary

Achieving market consistency can be challenging, even for the most established finance practitioners. In Market Consistency: Model Calibration in Imperfect Markets, leading expert Malcolm Kemp shows readers how they can best incorporate market consistency across all disciplines. Building on the author's experience as a practitioner, writer and speaker on the topic, the book explores how risk management and related disciplines might develop as fair valuation principles become more entrenched in finance and regulatory practice.This is the only text that clearly illustrates how to calibrate risk, pricing and portfolio construction models to a market consistent level, carefully explaining 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 illiquid positions. It 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 book also shows how to best mark-to-market illiquid assets and liabilities and to incorporate these valuations into solvency and other types of financial analysis; it indicates how to define and identify risk-free interest rates, even when the creditworthiness of governments is no longer undoubted; and it explores when practitioners should focus most on market consistency and when their clients or employers might have less desire for such an emphasis.Finally, the book analyses the intrinsic role of regulation and risk management within different parts of the financial services industry, identifying how and why market consistency is key to these topics, and highlights why ideal regulatory solvency approaches for long term investors like insurers and pension funds may not be the same as for other financial market participants such as banks and asset managers.

Table of Contents

Preface

Acknowledgements

Abbreviations

Notation

Introduction

Market consistency

The primacy of the 'market

Calibrating to the 'market'

Structure of the book

Terminology

When is and when isn't 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 'Market Consistent Valuations'

Introduction

The underlying purpose of a valuation

The importance of the 'marginal' 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

What do we mean by 'risk-free'?

Choosing between possible meanings of 'risk-free'

Liquidity Theory

Introduction

Market experience

Lessons to draw from market experience

General principles

Exactly what is liquidity?

Liquidity of pooled funds

Losing control

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 'Real World' 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 'Market Implied' 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

Incentive arrangements

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 investors' 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

Conclusions

Market consistent principles

Bibliography

Index

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