Cutting edge 2012: From stochastic volatility to shameful scams

Papers published in Risk this year touched on a diverse range of topics. Laurie Carver provides an overview and introduces the annual round-up of citations

Some years have obvious themes. In 2011, Risk’s technical section was dominated by work on the credit valuation adjustment (CVA) that reflects derivatives counterparty risk. The topic also figured in 2012, enabling counterparty credit expert Damiano Brigo of Imperial College to leapfrog Barclays’ Vladimir Piterbarg into first place in the rankings for the highest number of recent citations in Risk (table A - see link at the bottom of this article for all tables). But CVA was joined this year by a greater variety of topics, from stochastic volatility, stress testing and collateral management to more crusading work, such as an attempt to debunk the controversial debit valuation adjustment (DVA).

Technical standards remain high. Two papers on stochastic volatility – The beta stochastic volatility model by Artur Sepp of Bank of America Merrill Lynch and Piotr Karasinski of the European Bank for Reconstruction and Development, and Stochastic volatility’s orderly smile by Lorenzo Bergomi, head of quantitative research at Société Générale, and Julien Guyon, a Bloomberg quant – used sophisticated mathematics to probe the implied volatilities of such models, borrowing either from stochastic analysis or quantum field theory, depending on your perspective.

But not everything was so complicated. Attilio Meucci of hedge fund Kepos Capital offered Stress testing with fully flexible causal inputs, an article focused on intuitive scenario generation rather than simulation of abstract continuous distributions – and showed how to implement them on a portfolio using minimal mathematics. Meanwhile, Longwood Credit Partners’ Richard Martin – still Risk’s most published author with 18 articles (see table C) – contributed two papers, the second with his colleague Ali Bana, on algorithmic trading strategies that use market momentum, applying analytical tricks familiar to first-year undergraduates.

With the implementation of Basel III set to begin in many countries next year – even if Europe and the US continue to drag their heels – a look at the origin of the standardised CVA capital charge from a regulator was appropriate. Federal Reserve Board economist Michael Pykhtin showed the opaque formula was derived from a simple Gaussian model – but perhaps counter-intuitively, the supposedly conservative simplifications in the formula tended to decrease the required capital.

Collateral is another important theme for a world moving towards central clearing. One of the celebrated papers of 2010 – Funding beyond discounting: collateral and derivatives pricing from head Barclays quant Vladimir Piterbarg – received a sequel of sorts in Cooking with collateral by the same author. Although perhaps not as ground-breaking as its predecessor, it included pricing formulas for specific cases of collateralised derivatives, including when the credit support annex allows a choice of collateral currencies.

CVA was joined this year by a greater variety of topics, from stochastic volatility, stress testing, algorithmic trading, capital regulation, collateral management and computation costs to more crusading work

But perhaps the greatest leaps were made in numerical methods. One such technique is the so-called particle method, championed by the French school at Société Générale – in particular, quants Pierre Henry-Labordère and Julien Guyon, whose Being particular about calibration was published by Risk in January. It cuts the number of calculations involved in a multivariable simulation relative to Monte Carlo-in-Monte Carlo algorithms – that require a complete resimulation for each variable – by modelling outcomes as randomly moving particles with interactions governed by the variables’ dependencies. In July, Henry-Labordère applied the method successfully to CVA – notorious for its computational burden – in Cutting CVA’s complexity, in which the particles interacted by reproducing ‘offspring’, or recovery values upon default.

DVA – the flipside to CVA that accounts for a firm’s own default rather than that of its counterparty – has long been controversial. But Antonio Castagna went further than most, calling it a “shameful scam” when talking to Risk about his The impossibility of DVA replication.

Previously, a classic Risk paper from 2011 by Christoph Burgard and Mats Kjaer of Barclays had showed how a bank could monetise DVA by buying up its own debt. But Castagna sees it differently – the dealer can never be long something only it can issue, but can merely reduce its short position by buying its own bonds back, he argued. While this can be a funding benefit, it removes the funding for some other part of the balance sheet and therefore effectively acts as a cost. The paper is controversial, but not without fans, with one senior counterparty risk expert describing it as “something that needed to be said”.

The year also saw papers on model risk, fat tails, value-at-risk implementation and a host of other topics – diversity that can also be seen in the classic papers that have been most cited over the past 10 years (table D): the original stochastic volatility model of Stephen Heston; the stochastic alpha beta rho model of JP Morgan’s Patrick Hagan; the classic introduction of local volatility by Bruno Dupire of Bloomberg; Robert Merton’s seminal paper on credit-risky corporate debt; and the interest rates textbook written by Imperial College’s Brigo and Fabio Mercurio of Bloomberg.

 

Referenced articles

Being particular about calibration, Pierre Henry-Labordère and Julien Guyon, Risk January 2012, pages 88–93
Stress testing with fully flexible causal inputs, Attilio Meucci, Risk April 2012, pages 63–67
Stochastic volatility’s orderly smile, Lorenzo Bergomi and Julien Guyon, Risk May 2012, pages 60–66
Model foundations of the Basel III standardised CVA charge, Michael Pykhtin, Risk July 2012, pages 60–66
Cutting CVA’s complexity, Pierre Henry-Labordère, Risk July 2012, pages 67–73
Momentum trading: ‘skews me, Richard Martin, Risk August 2012, pages 40–45
Cooking with collateral, Vladimir Piterbarg, Risk August 2012, pages 46–51
Beta stochastic volatility model, Artur Sepp and Piotr Karasinski, Risk October 2012, pages 62–67
Non-linear momentum strategies, Richard Martin and Ali Bana, Risk November 2012
The impossibility of DVA replication, Antonio Castagna, Risk November 2012, pages 66–70

 

From stochastic volatility to shameful scams