Podcast: Hagan on convexity, volatility and the London Whale

For this episode of Quantcast, I speak with Patrick Hagan, the veteran quant who co-developed the ubiquitous SABR volatility model in 2002. He is now the managing director of Gorilla Science, a consultancy that develops quantitative models for pricing, hedging and managing risk in financial markets.

Hagan and Diana Woodward, a senior researcher at Gorilla Science, recently published an alternative solution to value convexity adjustments – a correction that accounted for the non-linear relationship between interest rates and prices in securities such as constant maturity swaps.

Their analytical formula overcomes the drawbacks of the replication method for valuing convexity adjustments, simplifying the hedging of vega risk for high strikes.

Hagan says the solution reduces the computational and operational burden associated with valuing convexity adjustments and has already been adopted by some financial institutions.

He also shares his take on new innovations in financial modelling, such as rough volatility, which he praises for its ability to truly capture market behaviour. He reveals that he is working on the so-called Levy flight, a process that also relies on fractional Brownian motion, but is more tractable than other Levy processes.

The conversation ends with a recollection of the London Whale incident in 2012, which cost JP Morgan $6 billion. Hagan says the loss resulted from the bank taking excessive exposure to credit default swaps at a time when the incoming Basel 2.5 rules made it very capital-intensive to do so, and other banks had exited the market.

The lessons from that loss, Hagan says, are that historical value-at-risk cannot always be trusted, and that exposures should never be allowed to balloon to a size that cannot be efficiently liquidated.

Nowadays, banks are safer as a result of regulation that has tamed their risk appetite. But risk in financial markets hasn’t been eliminated entirely – much of it has simply been pushed to the hedge funds industry. The dangers to the financial system, Hagan says, now lurk there.

Index

00:00 Introduction

01:30 The problems with convexity adjustments

03:35 How a closed form formula can replace replication

06:50 The potential of rough volatility models

08:32 What is Levy flight and how does it work?

18:35 The London Whale and the risk management failures that led to it

27:44 Where are the risks in the financial system now?

30:00 Future research projects: cryptocurrencies

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