Podcast: Colin Turfus on short-rate models and Libor’s end

Deutsche Bank quant proposes a lean model to quickly produce benchmark prices

Colin Turfus

Colin Turfus, a senior quant analyst at Deutsche Bank in London and author of Risky caplet pricing with backward-looking rates, is our guest for this episode of Quantcast.

Turfus has spent the past six to seven years working on analytic solutions for short-rate models, tracking the evolution of interest rates over time. This stream of research has progressively extended the classic Hull-White model for short rates to incorporate the risk-free rate, which is essential for the transition from interbank offered rates (Ibors). His latest paper builds on research he has published in the past. “This particular paper is the extension of these formulae to be able to handle, in addition, credit risk, where credit is stochastically variant and there is potentially wrong-way risk associated with that,” Turfus explains.

 

The Hull-White model is a short-rate model for pricing interest rates that may be stochastic. It has proven popular because it provides an analytic solution for the zero-coupon model and therefore facilitates the pricing of options and swaptions based on Libor. As he points out in this podcast, while this is highly desirable, it may come at a price of a less adaptable setting, which is harder to manage when one needs to price different products.

Turfus is a model validation quant, and these models were developed with that purpose in mind, as the availability of an analytic solution allows for the quick creation of benchmark prices. But he sees wider applications.

“The most interesting application I see in the longer term would probably be more in market risk, where even though you have fairly simple derivatives, you often have to value them in the context of a portfolio where there are multiple other underlyings,” says Turfus.

His work in this area is not done yet. The next step will be overcoming the limitation of having a time-dependent deterministic volatility, in order to be able to fit the volatility smile. Early tests show this direction of research gives good results and frees the way to a more complete version of Turfus’s model.

Index

00:00 Intro

01:25 Analytic solutions for short-rate models

03:15 The Hull-White model

04:17 The Mercurio-Lyashenko model

05:35 The Black-Karasinski model

06:36 Practical applications

12:12 Closed-form models vs Monte-Carlo approaches

14:48 Future research

To hear the full interview, listen in the player above, or download. Future podcasts in our Quantcast series will be uploaded to Risk.net. You can also visit the main page here to access all tracks, or go to the iTunes store or Google Podcasts to listen and subscribe.

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