emerging stress scenarios

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Emerging Stress ScenariosWednesday, Oct. 9, 2013 at 12 pm U.S. Eastern Time

Alan Laubsch Head of FNA LabsFinancial Network Analytics

Kimmo Soramäki Founder and CEOFinancial Network Analytics

2 www.fna.fi Kimmo Soramaki [email protected] Alan Laubsch [email protected] 2

Emerging Stress ScenariosIntroducing HeavyTails™ Network Analytics

PRMIA Webinar Oct 9, 2013

http://www.fna.fi/


1. Adaptive Stress Testing

• Signal or Noise?

2. HeavyTails™ Network Analytics

3. Network Stress Testing

4. Summary and Conclusions

Agenda

http://www.fna.fi/


I. Macro: identify structural risks (potential risks)• Stress Library based on Thought Leaders (Innovators)

• Awareness of systemic cycles, in particular credit and asset bubbles

• Financial or economic imbalances (e.g., capital flows, consumption vs. saving)

• Examples: Shiller – (a) tech bubble (2000) and (b) housing bubble (2005)

II. Micro: monitor potential precipitating events (visible risks)• Focus on short term market movements, especially outliers and regime

shifts

• Early Warning: identify amplification mechanisms and critical (tipping) points

• Examples: vol spike in (a) tech stocks and (b) US mortgage securities & financials

Adaptive Stress Testing Framework

http://www.fna.fi/


Source: Wikipedia; see Geoffrey Moore’s “Crossing the Chasm” (1999)

Two key perspectives for stress testing

1. Macro: Stress Scenario Library from Innovators

2. Micro: Market signals from Early Adopters

Social Adoption of Disruptive Innovation

http://www.fna.fi/


US Financials Case Study

Financial Meltdown (“Roubini”) scenario escalates from ’07 and peaks March ’09 and then declines… inverse Financial Recovery scenario emerges

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Feb 27 ‘07 outlier

Source: Alan Laubsch, “Equities as Collateral In U.S. Securities Lending Transactions”,

The RMA Executive Committee on Securities Lending & RiskMetrics, March 2011

March 6 Market bottom

June 1 Market peaks

Escalating vol bear marketDeclining vol bull

mkt

Chart: U.S. Financials “death star pulse”

http://www.fna.fi/







Agenda

http://www.fna.fi/


Dragon King (Sornette 2009)

Black Swan (Taleb 2001, 2007)

vs.

Two theories for crises

http://www.fna.fi/


Phase transitions can result from amplifying feedback

Super-exponential instability and change characterizes phase transitions

See: http://www.er.ethz.ch/presentations/Endo_Exo_Oxford_17Jan08.pdf

Source: Sornette et al., Endogenous versus Exogenous Origins of Crises (2008)

http://www.fna.fi/

http://www.er.ethz.ch/presentations/Endo_Exo_Oxford_17Jan08.pdf


Subprime CDO foreshocks: Tremors in Dec 2006 & Feb 2007 cascade into systemic meltdown

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The first tremor (vol up 300% Dec 12-21)

Feb 23 '07, first major outlier, 350% vol increase in 1 day, 12sd move

June 20 '07, ML tries to liquidate Bear Subprime CDO's

Absolute Spread Levels

Major ratings agencies initiate reviews and/or downgrades week of July 9 '07

bp's

Absolute spread moves were small, but rate of change was super-exponential. Parallels to

failure and rupture process in material science (pressure to break point)

http://www.fna.fi/


Subprime CDO VaR outlier analysis reveals the risk signals

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300%+ increase in vol from Dec 12 to 21 '06

357% vol spike on Feb 23 '07

RM 2006 99% VaR bands vs 2006-1 AAA spread changes

One major outlier, a 12 sd move on Feb 23 '07, the day after the $10.5bn HSBC loss announcement

Backtesting summary: 2.4% upside excessions0.81% downside excessions

Major ratings agencies initiate reviews and/or downgrades week of July 9 '07

Source: Alan Laubsch “Subprime Risk Management Lessons”, RiskMetrics

GS exits

subprime

http://www.fna.fi/


Polling question

Does your organization use market based early

warning signals?

1. YES

2. NO

http://www.fna.fi/







Agenda

http://www.fna.fi/


The Data

Pairwise correlations of daily returns on 35 global assets (ETFs), incl.

Equity indices

FX

Commodities

Debt

Derivatives

…

http://www.fna.fi/


The ETFs

http://www.fna.fi/


Significant Correlations

Common method to visualize large correlation matrices is via heat maps

Keep statistically significant correlations with 95% confidence level

Carry out 'Multiple comparison' -correction -> Expected error rate <5%

All correlations (last 100 days)

Statistically significant correlations (last 100 days)

http://www.fna.fi/


A and B are the same shade of gray

Right?

About Color Perception

http://www.fna.fi/


A and B are the same shade of gray

About Color Perception

http://www.fna.fi/


Correlation Network

Problem: Heatmaps can be misleading due to human color perception

Lets build some network approaches for visualizing correlations

http://www.fna.fi/


Correlation Network

Nodes are assets

Links are correlations:

Red = negativeBlack = positive

Absence of link marks that asset is not significantly correlated

http://www.fna.fi/


Minimum Spanning Tree

Rosario Mantegna (1999):

"Obtain the taxonomy of a portfolio of stocks traded in a financial market by using the information of time series of stock prices only“

We use the Minimum Spanning Tree (MST) of the network to filter signal from noise.

Hierarchical Structure in Financial Markets

http://www.fna.fi/


Re-positioning the Assets

We lay out the assets by

their hierarchical structure

using Minimum Spanning

Tree of the asset network.

Shorter links indicate higher

correlations. Longer links

indicate lower correlations.

http://www.fna.fi/


Network layout allows for the display of multiple dimensions of the same data set on a single map:

Node color indicates latest daily return- Green = positive- Red = negative

Node size indicates magnitude of return

Bright green and red indicate an outlier return

Mapping Returns and Outliers

http://www.fna.fi/


Polling Question 2

Which scenarios are of greatest concern to your institution?

1. Eurozone crisis redux

2. Emerging markets hard landing (China, India, SEA)

3. US precipitated liquidity or credit shock – default, tapering

4. Geopolitical instability (Syria, Iran, …)

5. Other

http://www.fna.fi/


Gold Early Warning Case study: downside outlier clustering

http://www.fna.fi/


DEMO HERE

Stress Scenarios (Demo using www.heavytails.com)

http://www.fna.fi/







Agenda

http://www.fna.fi/


Not clearly defined

We understand as: "The risk that a system

composed of many interacting parts fails

due to a shock to some of its parts"

- complex systems approach

Domino effects, cascading failures, financial

interlinkages, … -> i.e. a process in the

financial network

28

Not:

Systemic risk

http://www.fna.fi/


The Network for an Oil shock

http://www.fna.fi/


The Network for Multiple Shocks

http://www.fna.fi/


How do you take into account dependencies in your stress

scenarios?

1. Qualitative approach: subjective assessment of

repercussions

2. Quantitative approach: using correlation structure

3. Blend: combination of qualitative and quantitative (art and

science)

Poll Question 3

http://www.fna.fi/







Agenda

http://www.fna.fi/


Sense and Respond to emerging risks

1. Detect signals amidst noise - algorithms, visualization,

and human intelligence to

2. Model a credible sequence of shocks from key nodes

into the rest of the network

3. Keep your eyes open to the periphery, where

disruptive innovation arises

Anticipate

Most of the focus at most companies is on what’s directly ahead. The leaders lack “peripheral vision.” This can leave your company vulnerable to rivals who detect and act on ambiguous signals Source: “6 Habits of True Strategic Thinkers,” Paul Schoemaker, March 20 2012

http://www.fna.fi/


Conclusions

• Early detection and adaptation is crucial for

managing systemic risks

• HeavyTails™ amplifies market intelligence and

helps prioritize focus

• Spark Network Intelligence

“The future is already here. It’s just not evenly distributed yet.”

William Gibson

http://www.fna.fi/


Please join the PRMIA “Emerging Stress Themes” community on LinkedIn

Email us for discounts on the PRMIA Adaptive Stress Testing online course and community

Free beta trial version of HeavyTails™ for PRMIA members at www.heavytails.com

Thank You!

http://www.fna.fi/

http://www.linkedin.com/groups?gid=5061730

http://www.heavytails.com/

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