Risk-neutral modelling
Into the quantiverse: real-world pricing goes arbitrage-free
QRM quants claim to have bridged divide across ‘multiverse’ of fixed-income models
Risk-neutral densities: advanced methods of estimating nonnormal options underlying asset prices and returns
This work expands the analysis in Cooper (1999) and Santos and Guerra (2014), and the performance of the nonstructural models in estimating the "true" RNDs was measured through a process that generates "true" RNDs that are closer to reality, due to the…
Podcast: Princeton’s Carmona on the future of quant education
Course director discusses machine learning explainability and reclaiming game theory from economists
Time to move on from risk-neutral valuation?
Risk-neutral valuation could be replaced by models with a subjectivity element, writes mathematical finance head
Two measures for the price of one
Simulating exposures under the real-world measure followed by repricing under the risk-neutral measure is computationally intensive and dangerous shortcuts are often taken. Here, Harvey Stein combines the real-world measure with the risk-neutral measure…
Short-rate joint-measure models
John Hull, Alexander Sokol and Alan White introduce a new concept, called local price of risk, to construct and calibrate a joint-measure model describing the evolution of interest rates under both the real-world and risk-neutral measures. This can be…
Regulatory-optimal funding
Funding costs, both for derivatives trading and for more traditional bank lending, are set by treasury functions, which now must consider regulatory requirements such as the Basel III liquidity coverage ratio. But few studies look at how to optimise this…
In defence of FVA – a response to Hull and White
The funding valuation adjustment traders have been adding to derivatives prices since bank funding costs first blew out in 2008 has proved controversial, putting theory and practice at odds with one another. Royal Bank of Scotland’s Stephen Laughton and…
Traders close ranks against FVA critics
Derivatives desks have been passing along funding costs for uncollateralised trades since bank spreads blew out in the crisis. But a funding-dependent price is subjective – and this is intolerable to some quants and risk managers. A heated debate is now…
Cooking with collateral
In the wake of the crisis, the traditional assumption of a risk-free counterparty and rate has been shown to be false, yet it still underpins finance theory. Vladimir Piterbarg develops theoretical foundations for a model of an economy without a risk…
Q&A: Emanuel Derman on model risks, why quantitative finance is not a theory, and bailout ethics
The use of advanced mathematics and techniques from physics helped give credibility to the financial models that proved inadequate in the crisis. Here, Emanuel Derman, an old hand in the development of finance theory, calls for it to be reassessed – and…
Eurostoxx 50 investors 'unintentionally making a bet on financials', according to research
Tobam's analysis of financial markets diversification suggests that eurozone indexes might not be as diversified as investors believe
Trees from history
Volatility smile models and their variants are the preferred pricing method for dealers working within the risk-neutral world. However, such models use option prices as input parameters, making them less useful for assessing fair value. Risk-neutralised…
Risk and probability measures
Although its drawbacks are well known, VAR has become institutionalised as the market risk measure of choice among trading firms and regulators. Now there is a growing feeling that a reappraisal is overdue, exemplified here by Phelim Boyle, Tak Kuen Siu…
Modelling credit migration
Credit models are increasingly concerned not only withthe probability of default, but also with what happensto a credit on its way to default. Attention is being focusedon the probability of moving from one creditlevel, or rating, to another. One…
The tree of knowledge
Implied volatilities contain valuable information for options dealers, but how should thisinformation be incorporated into risk-neutral trees? Here, Isabelle Nagot and RobertTrommsdorff solve the problem in an analytically tractable framework