Markovian projection for equity,

xed income, and credit dynamics.

T. Misirpashaev
NumeriX
April 6, 2007
Financial Mathematics Seminar, Stanford University, 2007
NumeriX
Abstract
We begin with the classic result of Dupire which shows that any diusion model
with stochastic volatility can be reduced to a local volatility model without changing
the prices of European options. Specically, the value of the eective local volatility at
state S and time T is equal to the expectation of the stochastic volatility conditional
on achieving state S at time T. This leads to a technique of model calibration in
which the original model without a low-dimensional Markovian representation is
approximated by a low-dimensional Markovian model. We cite the results for the
projection on an eective displaced diusion and Heston models. We then set the goal
of extending the technique from diusions to jump processes used for dynamic
modeling of credit basket loss. We identify the one-step Markov chain as the
counterpart of the local volatility model and prove the version of the Dupire result
applicable to jump processes. We conclude by observing that the local intensity of the
eective Markov chain bears a distinctive signature of credit correlation skew, which
can be used to predict success or failure of certain models in matching the market of
CDO tranches.
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Outline
1. Classic Universal Theory of Volatility by Dupire
2. Modern applicatons: European option pricing by Markovian
projection
3. Extensions of the classic theory: Gyongy lemma for multidimensional
diusion processes and Markovian projection on stochastic volatility
models
4. Extension to jump processes: local intensity model
5. Applications to credit basket models: signature of correlation skew
2
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Dupires Universal Theory of Volatility (UTV)
Stochastic volatility model in the martingale measure: dX
t
=
t
dW
t
.
Local volatility model in the martingale measure: dY
t
= g(Y
t
, t)dB
t
.
(Note: W
t
may have several components, B
t
is 1-dimensional. )
Gyongy (1986) - Dupire (1997) lemma: one-dimensional marginal
distributions (and therefore European options) for X
t
and Y
t
are
identical provided X
0
= Y
0
and
g
2
(x, t) = E[|
t
|
2
|X
t
= x].
Dupire gave a formula for g(x, t) in terms of European options
C(K, T) = E[(X
T
K)
+
],
g
2
(K, T) =
C(K, T)/T
1
2

2
C(K, T)/K
2
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Modern applications of UTV: Markovian
Projection
Fast calculation of European options is essential for model calibration.
Markovian projection helps because European options can be priced in
an equivalent local volatility model.
How to compute the conditional expectation E[|
t
|
2
|X
t
= x]?
One way is to restrict the space of all local volatility functions g(x, t) to
a parametric subspace and do a regression, exploiting the minimizing
property of the conditional expectation
E[|
t
|
2
|X
t
= x] = g
2
(x, t) E[(|
t
|
2
g
2
(x, t))
2
] min
(For an alternative, see Avellaneda et al. 2002)
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Projection on a displaced diusion
Choose the subspace
g(x, t) = (X
0
+(t)(x X
0
))(t)
Find (t) and (t) from the minimizing property (Antonov and
Misirpashaev, 2006)
|(t)|
2
= E
_
|
t
|
2

(t) =
E
_
|
t
|
2
(x(t) X
0
)

2E [|
t
|
2
] E [(x(t) X
0
)
2
]
Average the shift parameter (Piterbarg, 2005)

T
=
_
T
0
(t)|(t)|
2
_
t
0
|()|
2
ddt
_
T
0
|(t)|
2
_
t
0
|()|
2
ddt
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Projection on a displaced diusion (contd)
Price the European option using the Black-Scholes formula
E[(X
T
K)
+
] =
X
0

T
N(d
+
)
_
K +
X
0
(1

T
)

T
_
N(d

),
d

=
ln
_
X
0
/(K

T
+X
0
(1

T
)
_
V/2

V
, V =

2
T
_
T
0
|(t)|
2
dt.
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Examples of projection on displaced diusion
All calculations can be completed in the leading order in volatilities for
the pricing of European options on the following processes
basket of equities
swap rate in a Libor Market Model
FX rate in a cross-currency Libor Market Model
For details, see Piterbarg (2006), Antonov and Misirpashaev (2006a,b)
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Extending the idea of Markovian projection
0. Markovian projection of drift (Universal Theory of No Volatility)
1. Markovian projection for a multi-component process with
applications to projections onto stochastic volatility models
2. Markovian projection for a jump process with applications to
top-down modeling of credit basket loss
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Dupires Universal Theory of no Volatility
(private communication, unpublished)
A process with stochastic drift dX
t
=
t
dt and another process with
local drift dY
t
= m(Y
t
, t)dt have the same marginal distributions
provided X
0
= Y
0
and
m(x, t) = E[
t
|X
t
= x]
The intended application was to model credit basket loss as a continuous
variable. We will see later how this changes in a framework with discrete
default events.
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Markovian projection with multiple components
Take an N-dimensional (non-Markovian) process
X(t) = {X
(1)
t
, , X
(N)
t
} with an SDE
dX
(n)
t
=
(n)
t
dt +
(n)
t
dW
t
The process X
t
can be mimicked with a Markovian N-dimensional
process Y
t
with the same joint distributions for all components at xed
t.
According to Gyongy, the process Y
t
satises the SDE
dY
(n)
t
= m
(n)
(Y
t
, t)dt +g
(n)
(Y
t
, t)dW
t
with
m
(n)
(x, t) = E[
(n)
t
|X
t
= x]
g
(n)
(x, t)g
(m)
(x, t) = E[
(n)
t

(m)
t
|X
t
= x]
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Choice of process components
The rst component is the rate, dS
t
=
t
dW
t
. (We set S
0
= 1).
The second component should be related to |
t
|
2
.
We x a shift function (t) (for example, from a projection on displaced
diusion) and write the equation for the rate in the form
dS
t
= (1 +(t)(S
t
1))
t
dW
t
where

t
=

t
1 +(t)(S
t
1)
The second equation is for the variance V
t
= |
t
|
2
,
dV
t
=
V
t
dt +
V
t
dW
t
This completes the SDEs for the non-Markovian pair {S
t
, V
t
}.
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Projection onto a stochastic volatility model
Target model
dS

t
= (1 +(t)(S

t
1))

z
t

H
(t)dW
t
dz
t
= (t) (1 z
t
)dt +

z
t

z
(t)dW
t
, z
0
= 1
Answer
|
H
(t)|
2
= E[V
t
]
(t) =
d
dt
(log E[V
t
])
1
2
d
dt
_
log E[V
2
t
]
_
+
E[|
V
t
|
2
]
2E[V
2
t
]
|
z
(t)|
2
=
E[V
t
|
V
t
|
2
]
E[V
2
t
]E[V
t
]
(t) =

z
t

H
t
|
H
t
| |
z
t
|
=
E[V
t

t

V
t
]
_
E[V
2
t
]E[V (t)|
V
t
|
2
]
where V
t
= V
t
E[V
t
].
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From stochastic intensity to local intensity:
Gyongy-Dupire for counting processes
N
t
has adapted stochastic intensity
t
M
t
has local intensity (M, t)
One-dimensional marginal distributions of N
t
and M
t
are identical
provided N
0
= M
0
and
(M, t) = E[
t
|N
t
= M].
(Lopatin and Misirpashaev, 2007). The counterpart of Dupires formula
is
(M, T) =
P[N
T
M]/T
P[N
T
M] P[N
T
M 1]
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Local intensity model (a.k.a. implied intensity
model and 1-step Markov chain)
Forward Kolmogorov equation for the density of loss distribution is easy
to solve
p(M, t)
t
= (M 1, t)p(M 1, t) (M, t)p(M, t).
Local intensity (M, t) is directly related to the loss distribution
(M, t) =
1
p(M, t)

t
M

n=0
p(n, t)
and turns out to bears a clear signature of the correlation skew.
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Sketch of intensity averaging formula proof
P[N
T
M]
T
=
E[1
N
T
M
]
T
=
E[E[1
N
T
M
|{

}, 0 T]]
T
=
E
_

M
n=0
1
n!
e

T
0

d
_
_
T
0

d
_
n
_
T
= E
_
_

M
n=0
1
n!
e

T
0

d
_
_
T
0

d
_
n
_
T
_
_
= E
_
_

T
e

T
0

d
_
_
T
0

d
_
M
_
_
= E[E[
T
1
N
T
=M
|{

}, 0 T]]
= E[
T
1
N
T
=M
] = E[
T
|N
T
= M] P[N
T
= M] ,
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Application of stochastic intensity counting
processes to top-down modeling of credit baskets
L
t
is a counting process conditional on an adapted stochastic intensity
process
t
. Examples:
Hawkes process
d
t
= ((t)
t
)dt +dL
t
More general ane process (Errais, Giesecke, and Goldberg, 2007)
d
t
= ((t)
t
)dt +
_

t
dW
t
+dL
t
+dJ
t
A minimal non-ane model (Lopatin and Misirpashaev, 2007)
d
t
= ((L
t
, t)
t
)dt +
_

t
dW
t
Calibration problem: how to recognize whether the model is capable of
producing the correlation skew?
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Correlation skew
3
6
9
12
22
0
10
20
30
40
50
60
0 5 10 15 20 25
attachment point
c
o
r
r
e
l
a
t
i
o
n
Market Skew
No Skew
Figure 1: Base correlations skew implied from iTraxx 5y CDO tranches on
Oct 12, 2005
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Relating intensity to skew is not straightforward
Deterministic intensity (t) produces no correlations (obvious, no default
clustering).
Stochastic intensity
t
can produce positive default correlations, however
the intuition about stronger default clustering does not necessarily result
in a stronger skew.
A more reliable indicator is needed to predict the ability of the model to
generate skew.
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Signature of correlation skew in local intensity
0
5
10
15
20
25
30
0 10 20 30 40
number of defaults
l
o
c
a
l

i
n
t
e
n
s
i
t
y
0% 5% 10% 15% 20% 25% 30%
attachment point
10% flat
25% flat
40% flat
Market skew
Figure 2: Local intensity consistent with at Gaussian correlations or
market correlations skew for iTraxx 5y (38) on Oct 12, 2005.
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Rules of thumb for the local intensity and
correlation skew
Flat local intensity no correlations
Sub-linear local intensity at correlations, no skew
Super-linear local intensity correlation skew
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From local intensity to base correlations skew
0%
10%
20%
30%
40%
50%
60%
0% 10% 20% 30% 40%
attachment point
b
a
s
e

c
o
r
r
e
l
a
t
i
o
n
=1+0.1N+0.025N;
p=6.9%
=0.5+0.35N; p=3.3%
=1+0.1N+0.02N;
p=9.5%
=1+0.5N; p=20.4%
=1+0.4N; p=14.3%
=1+0.25N; p=8.7%
=1; p=4.2%
Figure 3: Implied base correlations and expected loss from a given local
intensity. The number of assets is assumed to be 125, maturity 5y.
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Local intensity in ane models
d
t
= ((t)
t
)dt +
_

t
dW
t
+dL
t
+dJ
t
(J
t
has intensity h
0
+h
1

t
, jump size J)
E[
T
|L
T
= L] =
_
p(, L, T)d
_
p(, L, T)d
=

u
ln
__
2
0
dw
2
e
iwL
f(
0
, 0, u, w, 0)
_
|u=0
f(, L, u, w, t) = E[e
u
T
+iwL
T
|
t
= , L
t
= L]
f
t
+( )
f

+
1
2

2
f

2
+[f( +, L + 1, . . . ) f(, L, . . . )]
+(h
0
+h
1
) [f( +J, L, . . . ) f(, L, . . . )] = 0.
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Local intensity in ane models (contd)
(Due et al (2000); Giesecke and Goldberg, 2006; Errais et al, 2007)
t T t, f = exp(iwL +a(t) +b(t))
a(t) = b(t) +h
0
(e
Jb(t)1
), a(0) = 0,

b(t) = b(t) +
1
2

2
b(t)
2
+e
iw+b(t)
1 +h
1
(e
Jb(t)
1), b(0) = u.
This system is easily solved numerically
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Local intensity: Hawkes process
0
10
20
30
40
50
60
70
80
90
0 5 10 15 20 25 30
Number of defaults
L
o
c
a
l

i
n
t
e
n
s
i
t
y
Jump 1
Jump 1.25
Jump 1.5
Jump 1.75
Figure 4: Local intensity of the Hawkes process for dierent values of the
intensity jump upon default. Other parameters are = 1, = 0.3,
0
=1,
maturity 5y.
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Local intensity from stochastic intensity with jumps
0
10
20
30
40
50
60
70
80
0 5 10 15 20 25 30
Number of defaults
L
o
c
a
l

i
n
t
e
n
s
i
t
y
Jump 1
Jump 1.25
Jump 1.5
Jump 1.75
Figure 5: Local intensity from stochastic intensity for dierent values of
the intensity jump upon default. Other parameters are = 1, = 0.3,

0
=1, h
0
= 0, h
1
= 1, maturity 5y.
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Applicability of top-down ane models is
problematic
Local intensity in ane models typically grows slower than linear, hence
it will be dicult to count on a good calibration to the tranches.
We assumed a deterministic loss-given-default (LGD). Stochastic LGD
might improve the situation only if it is correlated with the loss and
or/intensity.
Alternatively, it makes sense to try going beyond the class of ane
models.
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A minimal non-ane model (Lopatin and
Misirpashaev, 2007)
d
t
= ((L
t
, t)
t
)dt +
_

t
dW
t
We now have sucient freedom to calibrate the entire surface of loss
distribution by adjusting the free function (L, t) for any volatility .
(Other forms of the diusion term are possible, also we could add
jumps.)
Calibration of (L, t) to the surface of loss (and the tranches) can be
done without simulation.
Instruments dependent on the dynamics can be computed either by a
forward simulation or by backward induction.
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Conclusions
Dupires theory of eective volatility gave birth to many non-trivial
applications and extensions, including
closed-form results for a projection on a displaced diusion
multi-component generalization and projections on stochastic
volatility models
projection on a Markov chain in the top-down credit basket
modeling. The counterpart of the local volatility is local intensity,
(N, t) = E[
t
|N
t
= N].
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References
A. Antonov and T. Misirpashaev (2006a) Markovian Projection onto a
Displaced Diusion: Generic Formulas with Applications, available at
SSRN: http://ssrn.com/abstract=937860.
A. Antonov and T. Misirpashaev (2006b) Ecient Calibration to FX
Options by Markovian Projection in Cross-Currency LIBOR Market
Models, available at SSRN: http://ssrn.com/abstract=936087.
M. Avellaneda, D. Boyer-Olson, J. Busca, and P. Friz (2002)
Reconstructing volatility, Risk, October, 8791.
B. Dupire (1997) A Unied Theory of Volatility, Banque Paribas
working paper, reprinted in Derivatives Pricing: the Classic Collection,
edited by P. Carr, Risk Books, London, 2004.
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E. Errais, K. Giesecke and L. Goldberg (2007) Pricing credit from the
top down with ane point processes, working paper, available at
defaultrisk.com.
K. Giesecke and L. Goldberg (2005) A top down approach to
multi-name credit, working paper, available at defaultrisk.com.
I. Gyongy (1986) Mimicking the One-Dimensional Marginal
Distributions of Processes Having an Ito Dierential Probability
Theory and Related Fields, 71, 501516.
A. V. Lopatin and T. Misirpashaev (2007) Two-Dimensional Markovian
Model for Dynamics of Aggregate Credit Loss, working paper, available
at defaultRisk.com
V. Piterbarg (2005) Time to smile, Risk, May
V. Piterbarg (2006) Markovian Projection Method for Volatility
Calibration, available at SSRN: http://ssrn.com/abstract=906473.
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