Professional Documents
Culture Documents
1. Applied Stochastic
2. Notes on Brownian
motion and related
The Wiener process, a mathematical model of randomness
phenomena
3. Random Walk 2
4. Random Walk
Stochastic Integration
Binomial Model
A simple model for an asset price random walk
Delta hedging
No arbitrage
Risk neutrality
Discrete Martingales
Binomial Model extended
Continuous Martingales
What is a continuous time martingale?
What is the probability that at a particular time the walker is at the origin?
The probability that a (one-dimensional) simple random walker returns to the origin infinitely often is one.
More generally, what is the probability distribution for the position of the walker?
Does the random walker keep returning to the origin or does the walker eventually leave forever?
A return to the origin, often referred to as an equalization, occurs when Sn equals 0 for some n greater than 0. If an in nite number of equalizations occur, then the
walk is called recurrent. If only a nite number of equalizations occur, then the walk is called transient.
Module 2: Quantitative Risk & Return
Portfolio
Management
Measuring risk and return
Benefits of diversification
Modern Portfolio Theory
and the Capital Asset
Pricing Model
The efficient frontier
Fundamentals of
Optimization and
Application to
Portfolio Selection
Fundamentals of portfolio
optimization
Formulation of
optimization problems
Solving unconstrained
problems using calculus
Kuhn-Tucker conditions
Derivation of CAPM
Evolution of Basel
Key provisions
Black-Scholes Model
The assumptions that go into the
Black-Scholes equation
Foundations of options theory: delta
hedging and no arbitrage
The Black-Scholes partial
differential equation
Modifying the equation for
commodity and currency options
The Black-Scholes formulae for
calls, puts and simple digitals
The meaning and importance of the
Greeks, delta, gamma, theta, vega
and rho
American options and early
exercise
Relationship between option values
and expectations
Martingale Theory –
Applications to Option
Pricing
The Greeks in detail
Higher-order Greeks
Richardson extrapolation
American-style exercise
Explicit finite-difference method for
two-factor models
ADI and Hopscotch methods
Exotic Options
Characterisation of exotic options
Time dependence (Bermudian
options)
Path dependence and embedded
decisions
Asian options
Delta Hedging
Bates Jump-Diffusion
Advanced Greeks
The names and contract details for
basic types of exotic options
How to classify exotic options
according to important features
How to compare and contrast
different contracts
Pricing exotics using Monte Carlo
simulation
Pricing exotics via partial differential
equations and then finite difference
methods
Advanced Volatility
Modelling in Complete
Markets
The relationship between implied
volatility and actual volatility in a
deterministic world
The difference between 'random'
and 'uncertain'
How to price contracts when
volatility, interest rate and dividend
are uncertain
Non-linear pricing equations
Optimal static hedging with traded
options
How non-linear equations make a
mockery of calibration
Market-Based Valuation of
Equity Index Options
Stylized Facts of Equity & Options
Markets
Numerically efficient valuation of
equity index options
Calibration of option pricing models
to market data
Simulation of option pricing models
for European & American options
Canonical Example
Euro Stoxx 50 index and options
Python implementation
Module 4: Fixed Income
Fixed Income Products
and Analysis
Names and properties of the
basic and most important fixed-
income products
Features commonly found in
fixed-income products
Simple ways to analyze the
market value of the instruments:
yield, duration and convexity
How to construct yield curves and
forward rates
Swaps
The relationship between swaps
and zero-coupon bonds
Stochastic Interest Rate
Modeling
Stochastic models for interest
rates
Risk bleeding
Scenarios-based risks and
hedging (wave method)
Current Market Practices
Advanced stripping
The drift
Factor reduction
Sensitivity calculations
Energy Derivatives
Participants' risk exposure in
electricity markets
Price volatility
Fluctuation of electricity
production costs
Hedging with electricity futures for
generators, marketers and end-
users
Risks of hedging with electricity
futures
"Stack and Roll" hedging for the
long-term periods
"Hedging with electricity options
and crack spreads
Speculation (views taking) using
electricity futures
Politics of Speculation. Dodd-
Frank Act
1. CREDIT RISK
Rating based 1. Sturctural models model credit risk based on assuming a stochastic
modeling of credit process for the value of the firm and the term structure of interest rates.
Modelling credit risk risk, Theory and Clearly the problem is to determine the value and volatility of the firm’s
application of assets and to model the stochastic process driving
migration the value of the firm adequately.
matricces.pdf
Basic structural models: Merton
Model, Black and Cox Model
Advanced structural models
Intensity Models
Modelling default by Poisson
Process
Relationship between intensity
and arrival time of default
Risky bond pricing: constant vs.
stochastic hazard rate
Bond pricing with recovery
Rank Correlation
Other Topics
1. They are more general than structural models and assume that an
exogenous random variable drives default and that the probability of default
(PD) over any time interval is non-zero. An important input to determine the
default probability and the price of a bond is the rating of the company. Thus,
to determine the risk of a credit portfolio of rated issuers one generally has to
consider historical average defaults and transition probabilities for current
rating classes. Quite often in reduced form approaches the migration from
Reduced Form Models
one rating state to another is modeled using a Markov chain model with a
migration matrix governing the changes from one rating state to another.
Besides the fact that they allow for realistic short-term credit spreads,
reduced form models also give great flexibility in specifying the source of
default.
2.
1. Analysts expect financial information about the company consisting of five
years of audited annual financial statements,the last several interim financial
statements, and narrative descriptions of operations and products. The
meeting with corporate management can be considered an important part of
an agency’s rating process. The purpose is to review in detail the company’s
key operating and financing plans, management policies, and other credit
1. CREDIT RISK
factors that have an impact on the rating.
Rating based
modeling of credit
A:
risk, Theory and
Although credit rating and credit score may be used interchangeably in
application of
some cases, there is a distinction between these two phrases. A credit
migration
rating, often expressed as a letter grade, conveys the creditworthiness of a
matricces.pdf
business or government. A credit score is also an expression of
creditworthiness, but it is expressed in numerical form and only used for
2.219148718-The-
individuals. Both ratings and scores are designed to show creditors a
Credit-Scoring-
borrower's likelihood of repaying a debt.
Toolkit-R-
Anderson.pdf
3. Credit Risk
2. Rating Facotrs: Business Risk || Financial Risk
Scorecards
Industry Characteristics || Financial Characteristics
Rating process Developing and
Competitive Position || Financial Policy
Implementing
Marketing || Profitability
Intelligent Credit
Technology || Capital Structure
Scoring.pdf
Efficiency || Cash Flow Protection
Regulation || Financial Flexibility
4.74973105-
Management
Consumer-Credit-
Source: S&P’s Corporate Ratings Criteria (2000)
Models-Pricing-
Profit-and-
In the world of emerging markets, rating agencies usually also incorporate
Portfolios-2009
country and sovereign risk to their rating analysis. Both business risk factors
such as macroeconomic volatility, exchange-rate risk, government
5. 242637835-Model-
regulation, taxes, legal issues, etc., and financial risk factors such as
Risk
accounting standards, potential price controls, inflation, and access.
6.rating_models_tc
3.The borrowers who share a similar risk profile are assigned to the same
m16-22933
rating grade. Afterwards a probability of default (PD) is assigned. Very often
the same PD is assigned to all borrowers of the same rating grade. For such
a rating methodology the PDs do not discriminate between better and lower
creditworthiness inside one rating grade. Consequently, the probability to
migrate to a certain other rating grade is the same for all borrowers having
the same rating grade.
1.A point-in-time (PIT) estimate refers to immediate In some cases, using several
probabilities, typically one-year, that will fluctuate up scorecards for a portfolio provides
and down over the course of an economic cycle. In Objectives better risk differentiation than using
contrast, a through-the-cycle (TTC) estimate is one that one scorecard on everyone. This is
approximates a stressed bottom-of-the-cycle scenario, • Reduction in bad usually the segmentation case
with a horizon of five years or more. debt/bankruptcy/claims/fraud where a population is made up of
• Increase in approval rates or market share distinct subpopulations, and
2, According to Aguais (2005), no risk estimate will ever in areas such as secured where one scorecard will not work
be purely PIT or TTC, but will+D56 loans, where low delinquency presents efficiently for all of them (i.e., we
always be a combination of the two. For example, expansion opportunities assume that different characteristics
default estimates based upon account performance • Increased profitability are required to predict risk for the
or the value of traded securities tend towards PIT, while • Increased operational efficiency (e.g., to different subpopulations in our
rating agency grades tend better manage workflow portfolio).
towards TTC. All of them will vary over an economic in an adjudication environment)
cycle, some more than others. • Cost savings or faster turnaround through 1. Generating segmentation ideas
Companies’ own internal grades are made up of a automation of adjudication based on experience and industry
combination of ‘subjective assessments, using scorecards knowledge, and then validating
statistical models, market information, and agency • Better predictive power (compared to these ideas using analytics
ratings’ that have a mixture of different existing custom or bureau 2. Generating unique segments
time horizons. While it may be ideal to provide separate scorecard) using statistical techniques such as
PIT and TTC estimates for each clustering or decision trees
obligor, this is beyond the capabilities of today’s banks, Data
and has not been required by Basel II. Typical segmentation areas used in
The following data items are usually the industry include those based on:
3. Stages of Scorecard Development collected for applications from the previous
two to five years, or from a large enough • Demographics. Regional
Feasibility study sample: province/state, internal definition,
• Account/identification number urban/rural, postal-code based,
Data—Will there be sufficient data available to develop • Date opened or applied neighborhood), age, lifestyle code,
a model? • Arrears/claims history over the life of the time at bureau, tenure at bank
Resources—Will there be money and people available? account
Technology—Is the technology available to support us? • Accept/reject indicator • Product Type. Gold/platinum cards,
• Product/channel and other segment length of mortgage, insurance type,
Player Identification identifiers secured/unsecured, new versus
• Current account status (e.g., inactive, used leases for auto, size of loan.
Project manager—Reports to the champion, and must closed, lost, stolen, fraud, etc.
advise of any resource requirements • Sources of Business (channel).
or shortfalls. As a rule of thumb, for application corecard Store-front, take one, branch,
Scorecard developer—Develops the actual scorecard. development there should be pproximately internet, dealers, brokers
Internal analysts—Assist in assembling and 2,000 “bad” accounts and 2,000 “good” segmentation
understanding data. accounts that can be randomly selected for
Functional experts—Assist in understanding the each proposed scorecard, from a group of
business and affected areas, and will be key when approved accounts opened within a defined Statistically-Based Segmentation
deciding upon the strategies to be employed. time frame. For behavior scorecards, these
Technical resources—Responsible for final would be from a group of accounts that Clustering
implementation of the scorecard. were current at a given point in time, or at a
certain delinquency status for collections Clustering is a widely used
Data Preparation scoring. A further 2,000 technique to identify groups that
declined applications may also be required are similar to each other with
Project scope—Which cases are to be included? for application scorecards where reject respect to the input variables.
Good/bad definition—What is to be predicted? inference is to be performed. Clustering, which can be used to
Sample windows—What will be the observation and segment databases, places objects
outcome periods? .Exclusions into groups, or “clusters,” suggested
The first step is to measure the Behavioural scores estimate the The use of nonlinear model functions as well as the maximum likelihood
improvement in predictive power risk that the borrower will default method to optimize those functions means that regression models also
through segmentation. This can be in the next 12 months. They are make it possible to calculate membership probabilities and thus to
done using a number of statistics obtained by taking a sample of determine default probabilities directly from the model function.
such as the Kolmogorov-Smirnov previous borrowers and relating
(KS), c-statistic, and so on. Exhibit
their characteristics, including their The curves of the model functions and their mathematical representation
4.13 shows an example of this repayment, arrears and usage are shown in chart 17. In this chart, the function denotes the cumulative
analysis using the c-statistic (details
during a performance period, with standard normal distribution, and the term (P) stands for a linear
on their default status 12 months after combination of the factors input into the rating model; this combination can
the c-statistic are covered later, in
the end of that performance also contain a constant term. By rescaling the linear term, both model
Chapter 6). period.Some of these functions can be adjusted to yield almost identical results. The results of the
characteristics indicate whether two model types are therefore not substantially different.
We assume that a proper or the borrower can afford to repay
sufficient score s(x) captures as the loan, but the most important Due to their relative ease of mathematical representation, logit models are
much information for predicting the characteristics are usually those used more frequently for rating modeling in practice. The general manner in
probability of a performance from the credit bureau and which regression models work is therefore only discussed here using the
outcome, say good/bad, as does the information on the arrears status of logistic regression model (logit model) as an example.
original data vector, x. the borrower.
P = 1/ (1+ exp ( - (b0 + b1 K1 + b2 K2 + bnKn)))
Now we consider three approaches A borrower is usually assumed to
to modelling the credit risk of have defaulted if their payments In this formula, n refers to the number of financial indicators included in the
portfolios of consumer loans, all of on the loan are more than 90 days scoring function, Ki refers to the specific value of the creditworthiness
which are based on the behavioural overdue. If we define those who criterion, and bi stands for each indicator s coefficient within the scoring
scores of the individual borrowers have defaulted as “bad” (B) and function (for i ¼ 1; :::n). The constant b0 has a decisive impact on the value
who make up the portfolio. those who have not defaulted as of p (i.e. the probability of membership).
“good” (G), then the behavioural
The three models have analogies score is essentially a sufficient Selecting an S-shaped logistic function curve ensures that the p values fall
with the three main approaches to statistic of the probability of the between 0 and 1 and can thus be interpreted as actual probabilities. The
corporate credit-risk modelling: a borrower being good. typical curve of a logit function is shown again in relation to the result of the
structural approach, a reduced-form exponential function (score) in chart 18.
defaultmode approach and a Thus, if x are the characteristics of
ratings-based reduced-form the borrower, a score s(x) has the Years @ address
approach. property that P(G | x) = P(G | s(x)) <3 years
3–6 years
>6 years
Blank
Years @ employer
<2 years
2–8 years
9–20 years
>20 years
Blank
Home phone
Y/N
Accom. status
Own
Rent
Parents
Other
Application score—Used for new business In retail credit, lenders strive to automate as many
origination, and combines data from the decisions as possible. The motivation for human input
customer, past dealings, and the credit arises only where the models are known to be weak, the
bureaux. value at risk is large, and/or the potential profit is high.
Behavioural score—Used for account
management (limit setting, over-limit Instances where judgmental assessments dominate are
management, authorisations), and usually insovereign, corporate, and project-finance lending, where
focuses upon the behaviour of an individual the borrowers’ financial situation is complex, the information
account. is not standard and/or difficult to interpret, and volumes are
Collections score—Used as part of the extremely low.If there is a scoring model, it will only be
collections process, usually to drive predictive used for guidance, and the underwriter will assess other
diallers in outbound call centres, and information that has not been incorporated in the score.
incorporates behavioural, collections, and
bureau data. The internal versus external rating issue is primarily the
Customer score—Combines behaviour on bespoke versus generic debate:
many accounts, and is used for both account Most internal ratings are provided by bespoke models
management and cross-sales to existing developed specifically for a lender, while external ratings
customers. are generics based upon the experience of many lenders,
Bureau score—A score provided by the credit that are also available to competitors. For retail credit, the
bureau, usually a delinquency or bankruptcy latter may be provided by credit bureaux, or co-operatives.
predictor that summarises the data held by Generics are often used by lenders that: (i) are small, and
them. cannot provide sufficient data for a bespoke development;
(ii) are looking to enter new markets, where they have no
Markets where credit scoring is used today experience; or (iii) lack the technological sophistication to
include, but are not limited to: develop and implement a bespoke system.
Unsecured—Credit cards, personal loans, Application scoring traditionally has assessed a very
overdrafts. specific default risk. The most common risk considered is
Secured—Home loan mortgages, motor the chance that an applicant will go 90 days overdue on
vehicle finance. their payments in the next 12 months. What would happen
Store credit—Clothing, furniture, mail order. over other time periods and whether the customer is
Service provision—Phone contracts, proving profitable to the lender are aspects not considered
municipal accounts, short-term insurance. in this assessment.
Enterprise lending—Working-capital loans,
trade credit. Ascore, s(x), is a function of the characteristics’ attributes x
of a potential borrower which can be translated into the
Request -> Application probability estimate that the borrower will be good.The
Time -> Behavioural critical assumption in credit scoring is that the score is all
Entry -> Recovery that is required for predicting the probability of the applicant
Transaction -> Fraud being good. In some ways the score is like a sufficient
Event warning -> Behavioural/fraud statistic. It is also usual to assume that the score has a
Campaign -> Response monotonic increasing relationship with the probability of
being good – in that case the score is called a monotonic
Request—Customer application for a specific score.
product, or increased facilities.
Time—Regular recalculation, such as
monthly.
Entry—Calculated on first entry into a specific
stage
of the CRMC, and the resultant score is
retained for future use.
Transaction—Customer already has the
product, and scores are calculated each time
Module 6: Big Data and
Machine Learning
Big Data in Finance
What is Data science?
Introduction to Classification
Bayesian Models and inference using
Markov chain Monte-Carlo
Introduction to graphical models: Bayesian
networks, Markov networks, inference in
graphical models
Optimisation techniques
Examples: Predictive analytics/trading &
Pricing
Classification, Clustering and
filtering
Classification: K-nearest neighbours,
optimal Bayes classifier, naïve Bayes, LDA
and QDA, reduced rank LDA, Logistic
regression, Support Vector Machines
Examples
Econometric methods
Co-Integration using R
Multivariate time series analysis
Financial time series: stationary and unit
root
Eagle-Granger Procedure
3. Now for each numeric variable create intervals and for each
category variable with different levels calculate WOEs and IVs.
Each bucket/bin should contain 5% of observations. The
variables with IV less than 0.1 and more than 0.5 should be kept
of analysis; they are under predictive or over predictive.
e. Run the proc Reg with VIF option to detect the co-
linearity, remove the variable with VIF greater than 5.
f. Now run corr and create a table of speaman and
hoffding value, remove values with low rank of
spearsman and high rankof hoffding value, they indicate
nonlinearity, its called nonlinearity screening
g. Next step to adjust outlier using percentile treatment
outcome:
Information odd :
O (G | X) = p (X) . p (G | X) / p(X) . p (B | X)
= p (G | X) / p (B | X)
O (G | X) = p (G | X) / p (B | X)