Market Consistency : Model Calibration in Imperfect Markets

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  • Edition: 1st
  • Format: Hardcover
  • Copyright: 2009-10-12
  • Publisher: Wiley
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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

Market consistency
The primacy of the æmarket
Calibrating to the æmarketÆ
Structure of book
When is and when isnÆt market consistency appropriate?
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
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
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

5.2 What do we mean by ærisk-freeÆ?

Choosing between possible meanings of ærisk-freeÆ
Liquidity theory
Market experience
Lessons to draw from market experience
General principles
Exactly what is liquidity?
Liquidity of pooled funds
Risk measurement theory&
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
Financial stability
Pension funds
Different types of capital
Calibrating risk statistics to perceived æreal worldÆ distributions
Referring to market values
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
Market implied risk modelling
Fully market consistent risk measurement in practice
Avoiding undue pro-cyclicality in regulatory frameworks
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
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
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
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