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Transcript of MarkovianProjectionMisirpashaev06Apr2007
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Markovian projection for equity,
fixed income, and credit dynamics.
T. Misirpashaev
NumeriX
April 6, 2007
Financial Mathematics Seminar, Stanford University, 2007
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Abstract
We begin with the classic result of Dupire which shows that any diffusion model
with stochastic volatility can be reduced to a local volatility model without changing
the prices of European options. Specifically, the value of the effective local volatility at
state S and time T is equal to the expectation of the stochastic volatility conditional
on achieving state S at time T. This leads to a technique of model calibration in
which the original model without a low-dimensional Markovian representation is
approximated by a low-dimensional Markovian model. We cite the results for the
projection on an effective displaced diffusion and Heston models. We then set the goal
of extending the technique from diffusions to jump processes used for dynamic
modeling of credit basket loss. We identify the one-step Markov chain as the
counterpart of the local volatility model and prove the version of the Dupire result
applicable to jump processes. We conclude by observing that the local intensity of the
effective Markov chain bears a distinctive signature of credit correlation skew, which
can be used to predict success or failure of certain models in matching the market of
CDO tranches.
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Outline
1. Classic Universal Theory of Volatility by Dupire
2. Modern applicatons: European option pricing by Markovian
projection
3. Extensions of the classic theory: Gyongy lemma for multidimensional
diffusion processes and Markovian projection on stochastic volatility
models
4. Extension to jump processes: local intensity model
5. Applications to credit basket models: signature of correlation skew
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Dupires Universal Theory of Volatility (UTV)
Stochastic volatility model in the martingale measure: dXt = tdWt.
Local volatility model in the martingale measure: dYt = g(Yt, t)dBt.
(Note: Wt may have several components, Bt is 1-dimensional. )
Gyongy (1986) - Dupire (1997) lemma: one-dimensional marginal
distributions (and therefore European options) for Xt and Yt are
identical provided X0 = Y0 and
g2(x, t) = E[|t|2|Xt = x].Dupire gave a formula for g(x, t) in terms of European options
C(K, T) = E[(XT K)+],
g2(K, T) =C(K, T)/T
12
2C(K, T)/K2
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Modern applications of UTV: Markovian
Projection
Fast calculation of European options is essential for model calibration.
Markovian projection helps because European options can be priced in
an equivalent local volatility model.
How to compute the conditional expectation E[|t|2
|Xt = x]?One way is to restrict the space of all local volatility functions g(x, t) to
a parametric subspace and do a regression, exploiting the minimizing
property of the conditional expectation
E[|t|2|Xt = x] = g2(x, t) E[(|t|2 g2(x, t))2] min(For an alternative, see Avellaneda et al. 2002)
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Projection on a displaced diffusion
Choose the subspace
g(x, t) = (X0 + (t)(x X0))(t)Find (t) and (t) from the minimizing property (Antonov and
Misirpashaev, 2006)
|(t)
|2 = E|t|
2(t) =
E|t|2(x(t) X0)
2E[|t|2] E[(x(t) X0)2]Average the shift parameter (Piterbarg, 2005)
T =T0
(t)|(t)
|2 t
0 |()
|2ddtT
0|(t)|2 t
0|()|2ddt
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Projection on a displaced diffusion (contd)
Price the European option using the Black-Scholes formula
E[(XT K)+] = X0TN(d+)
K+
X0(1 T)T
N(d),
d = ln
X0/(KT + X0(1 T) V /2V
, V = 2TT0
|(t)|2dt.
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Examples of projection on displaced diffusion
All calculations can be completed in the leading order in volatilities for
the pricing of European options on the following processes
basket of equities swap rate in a Libor Market Model
FX rate in a cross-currency Libor Market ModelFor details, see Piterbarg (2006), Antonov and Misirpashaev (2006a,b)
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Extending the idea of Markovian projection
0. Markovian projection of drift (Universal Theory of No Volatility)
1. Markovian projection for a multi-component process with
applications to projections onto stochastic volatility models
2. Markovian projection for a jump process with applications to
top-down modeling of credit basket loss
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Dupires Universal Theory of no Volatility
(private communication, unpublished)
A process with stochastic drift dXt = tdt and another process with
local drift dYt = m(Yt, t)dt have the same marginal distributions
provided X0 = Y0 and
m(x, t) = E[t
|Xt = x]
The intended application was to model credit basket loss as a continuous
variable. We will see later how this changes in a framework with discrete
default events.
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Markovian projection with multiple components
Take an N-dimensional (non-Markovian) process
X(t) = {X(1)t , , X(N)t } with an SDEdX
(n)t =
(n)t dt +
(n)t dWt
The process Xt can be mimicked with a Markovian N-dimensional
process Yt with the same joint distributions for all components at fixed
t.According to Gyongy, the process Yt satisfies the SDE
dY(n)t = m
(n)(Yt, t)dt + g(n)(Yt, t)dWt
with
m(n)(x, t) = E[(n)t |Xt = x]g(n)(x, t)g(m)(x, t) = E[(n)t (m)t |Xt = x]
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Choice of process components
The first component is the rate, dSt = tdWt. (We set S0 = 1).
The second component should be related to |t|2.
We fix a shift function (t) (for example, from a projection on displaced
diffusion) and write the equation for the rate in the form
dSt = (1 + (t)(St 1))tdWtwhere
t =t
1 + (t)(St 1)The second equation is for the variance Vt = |t|2,
dVt = Vt dt +
Vt dWt
This completes the SDEs for the non-Markovian pair {St, Vt}.
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Projection onto a stochastic volatility model
Target model
dSt = (1 + (t)(St 1))ztH(t)dWt
dzt = (t) (1 zt)dt + zt z(t)dWt, z0 = 1Answer
|H(t)|2
= E[Vt](t) =
d
dt(log E[Vt]) 1
2
d
dt
log E[V2t ]
+
E[|Vt |2]2E[V2t ]
|z(t)|2 = E[Vt|Vt |2]
E[V2t ]E[Vt]
(t) = z
t H
t|Ht | |zt | = E[Vtt
V
t ]E[V2t ]E[V(t)|Vt |2]
where Vt = Vt E[Vt].
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From stochastic intensity to local intensity:
Gyongy-Dupire for counting processes
Nt has adapted stochastic intensity t
Mt has local intensity (M, t)
One-dimensional marginal distributions of Nt and Mt are identical
provided N0 = M0 and
(M, t) = E[t|Nt = M].(Lopatin and Misirpashaev, 2007). The counterpart of Dupires formula
is
(M, T) = P[NT M]/TP[NT M] P[NT M 1]
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Local intensity model (a.k.a. implied intensity
model and 1-step Markov chain)
Forward Kolmogorov equation for the density of loss distribution is easy
to solve
p(M, t)
t = (M 1, t)p(M 1, t) (M, t)p(M, t).Local intensity (M, t) is directly related to the loss distribution
(M, t) = 1p(M, t)
t
M
n=0p(n, t)
and turns out to bears a clear signature of the correlation skew.
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Sketch of intensity averaging formula proof
P[NT M]T
=E[1NTM]
T=
E[E[1NTM|{}, 0 T]]T
=E
Mn=0
1n!e
T
0d
T0
dn
T
= EMn=0 1n!e
T
0dT
0 dn
T
= E
Te
T
0d
T0
d
M
= E [E [T1NT=M|{}, 0 T]]= E [T1NT=M] = E [T|NT = M] P [NT = M] ,
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Application of stochastic intensity counting
processes to top-down modeling of credit baskets
Lt is a counting process conditional on an adapted stochastic intensity
process t. Examples:
Hawkes process
dt = ((t) t)dt + dLt
More general affine process (Errais, Giesecke, and Goldberg, 2007)
dt = ((t) t)dt +
tdWt + dLt + dJt
A minimal non-affine model (Lopatin and Misirpashaev, 2007)
dt = ((Lt, t)
t)dt + tdWt
Calibration problem: how to recognize whether the model is capable of
producing the correlation skew?
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Correlation skew
3
6
9
12
22
0
10
20
30
40
50
60
0 5 10 15 20 25
attachment point
correlation
Market Skew
No Skew
Figure 1: Base correlations skew implied from iTraxx 5y CDO tranches on
Oct 12, 2005
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Relating intensity to skew is not straightforward
Deterministic intensity (t) produces no correlations (obvious, no default
clustering).
Stochastic intensity t can produce positive default correlations, howeverthe intuition about stronger default clustering does not necessarily result
in a stronger skew.
A more reliable indicator is needed to predict the ability of the model to
generate skew.
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Signature of correlation skew in local intensity
0
5
10
15
20
25
30
0 10 20 30 40
number of defaults
loca
lintensity
0% 5% 10% 15% 20% 25% 30%
attachment point
10% flat
25% flat
40% flat
Market skew
Figure 2: Local intensity consistent with flat Gaussian correlations or
market correlations skew for iTraxx 5y (38) on Oct 12, 2005.
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From local intensity to base correlations skew
0%
10%
20%
30%
40%
50%
60%
0% 10% 20% 30% 40%
attachment point
base
correlation
=1+0.1N+0.025N;
p=6.9%=0.5+0.35N; p=3.3%
=1+0.1N+0.02N;p=9.5%
=1+0.5N; p=20.4%
=1+0.4N; p=14.3%
=1+0.25N; p=8.7%
=1; p=4.2%
Figure 3: Implied base correlations and expected loss from a given local
intensity. The number of assets is assumed to be 125, maturity 5y.
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Local intensity in affine models
dt = ((t) t)dt + tdWt + dLt + dJt(Jt has intensity h0 + h1t, jump size J)
E[T|LT = L] = p(,L,T)d
p(,L,T)d
=
u
ln2
0
dw
2
eiwLf(0, 0,u,w, 0)|u=0
f(,L,u,w,t) = E[euT+iwLT |t = , Lt = L]
f
t + ( )f
+1
2 2
2f
2 + [f( + , L + 1, . . . ) f( , L , . . . )]+(h0 + h1) [f( + J , L , . . . ) f( , L , . . . )] = 0.
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Local intensity in affine models (contd)
(Duffie et al (2000); Giesecke and Goldberg, 2006; Errais et al, 2007)
t T t, f = exp(iwL + a(t) + b(t))
a(t) = b(t) + h0(eJb(t)1
), a(0) = 0,
b(t) = b(t) + 12
2b(t)2 + eiw+b(t) 1 + h1(eJb(t) 1), b(0) = u.
This system is easily solved numerically
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Local intensity: Hawkes process
0
10
20
30
40
50
60
70
80
90
0 5 10 15 20 25 30
Number of defaults
Localintensity
Jump 1
Jump 1.25
Jump 1.5
Jump 1.75
Figure 4: Local intensity of the Hawkes process for different values of the
intensity jump upon default. Other parameters are = 1, = 0.3, 0=1,
maturity 5y.
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Local intensity from stochastic intensity with jumps
0
10
20
30
40
50
60
70
80
0 5 10 15 20 25 30
Number of defaults
Localintensity
Jump 1
Jump 1.25
Jump 1.5
Jump 1.75
Figure 5: Local intensity from stochastic intensity for different values of
the intensity jump upon default. Other parameters are = 1, = 0.3,
0=1, h0 = 0, h1 = 1, maturity 5y.
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Applicability of top-down affine models is
problematic
Local intensity in affine models typically grows slower than linear, hence
it will be difficult to count on a good calibration to the tranches.
We assumed a deterministic loss-given-default (LGD). Stochastic LGD
might improve the situation only if it is correlated with the loss and
or/intensity.
Alternatively, it makes sense to try going beyond the class of affinemodels.
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A minimal non-affine model (Lopatin and
Misirpashaev, 2007)
dt = ((Lt, t) t)dt +
tdWt
We now have sufficient freedom to calibrate the entire surface of loss
distribution by adjusting the free function (L, t) for any volatility .
(Other forms of the diffusion term are possible, also we could addjumps.)
Calibration of (L, t) to the surface of loss (and the tranches) can be
done without simulation.
Instruments dependent on the dynamics can be computed either by a
forward simulation or by backward induction.
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Conclusions
Dupires theory of effective volatility gave birth to many non-trivial
applications and extensions, including
closed-form results for a projection on a displaced diffusion multi-component generalization and projections on stochastic
volatility models
projection on a Markov chain in the top-down credit basketmodeling. The counterpart of the local volatility is local intensity,
(N, t) = E[t|
Nt
= N].
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References
A. Antonov and T. Misirpashaev (2006a) Markovian Projection onto a
Displaced Diffusion: Generic Formulas with Applications, available at
SSRN: http://ssrn.com/abstract=937860.
A. Antonov and T. Misirpashaev (2006b) Efficient Calibration to FX
Options by Markovian Projection in Cross-Currency LIBOR Market
Models, available at SSRN: http://ssrn.com/abstract=936087.
M. Avellaneda, D. Boyer-Olson, J. Busca, and P. Friz (2002)
Reconstructing volatility, Risk, October, 8791.
B. Dupire (1997) A Unified Theory of Volatility, Banque Paribasworking paper, reprinted in Derivatives Pricing: the Classic Collection,
edited by P. Carr, Risk Books, London, 2004.
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E. Errais, K. Giesecke and L. Goldberg (2007) Pricing credit from the
top down with affine point processes, working paper, available at
defaultrisk.com.K. Giesecke and L. Goldberg (2005) A top down approach to
multi-name credit, working paper, available at defaultrisk.com.
I. Gyongy (1986) Mimicking the One-Dimensional Marginal
Distributions of Processes Having an Ito Differential Probability
Theory and Related Fields, 71, 501516.
A. V. Lopatin and T. Misirpashaev (2007) Two-Dimensional Markovian
Model for Dynamics of Aggregate Credit Loss, working paper, available
at defaultRisk.com
V. Piterbarg (2005) Time to smile, Risk, May
V. Piterbarg (2006) Markovian Projection Method for Volatility
Calibration, available at SSRN: http://ssrn.com/abstract=906473.
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