riskminds magazine

MagazineThe Biggest Short-Term Threat To Global Growth - Lord Adair Turner

Managing Risk In The Real World - Nassim Taleb

Misbehavioural Psychology - Emanual Derman

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After months of planning, RiskMinds has finally arrived and I am so excited to be here with you in Amsterdam! The conference features CROs, global supervisors,

economists, academics, practitioners, board members, cyber security experts and even a professional poker player this year. There is so much going on so I urge you to plan your week carefully!

Here are two new opportunities for 2014 that I wanted to make you aware of:

The engaged CRO conversations on Wednesday afternoon - join this proactive stream featuring big picture discussions and small working groups. You will be at the center of the discussions!

The MyRiskMinds event planner – make sure you download this on your phone and laptop so you can plan your week, see who’s attending and arrange to meet with old friends and new acquaintances.

If you have any thoughts or feedback on RiskMinds, please do come and say hello to the team!

Kind regards,

Victoria Chatterton Conference Director

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Victoria

Here are some top-pick sessions

for the week:■ Lord Adair Turner, former Chairman of the FSA speaking on the future for banking reform.

■ Renowned economist Willem Buiter of Citi examining the current and predicted economic trends.

■ Major General Jonathan Shaw delivering key messages from the front line of cyber security.

■ Professor Didier Sornette offering advice on how to spot and prepare for financial bubbles.

■ Emmanuel Derman, Nassim Taleb and Jon Danielsson debating model risk in the real world.

Welcome to the exclusive RiskMinds magazine, profiling some of the incredible practitioners and inspirational thoughtleaders speaking at RiskMinds International this year.

Please read, enjoy and take home with you!

W e L C O M e T O R i S K M i n D S

RiskMinds magazine

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Special Thanks To The Following:Magazine Editor : Amos RojterRiskMinds Director: Victoria ChattertonBusiness Development: Luke Raphael, Rustum Bharucha

Design & Layout: Lock On Productions Ltd.lockonproductions.comPublication Printer: Trio Offset Ltd.

Eight Ways To Make The Most Of RiskMinds ..............................................Page 2

Welcome to RiskMinds .......................................................................................Page 3

China's Balancing Act .........................................................................................Page 6

Managing Risk In The Real World ...................................................................Page 8

Would The New Reforms Have Saved Dexia ........................................... Page 10

Misbehavioural Psychology ............................................................................Page 12

The Illusion Of The Irrelevance Of The Long Term .................................Page 14

Interest Rate Modeling .................................................................................... Page 16

A Creepy Bubbling World .............................................................................. Page 17

Interview With Professor Damiano Brigo ...................................................Page 18

Measuring The Intangibles ............................................................................ Page 20

RiskMinds Social Events .................................................................................. Page 21

Meet The Team .................................................................................................. Page 22

Future RiskMinds Events ................................................................................ Page 24

Contentsi n S i D e T h i S i S S u e


RiskMinds magazine What do you think? - #RISKMINDS

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Industrial value added fell in August, credit growth has slowed dramatically, and housing prices

are falling, with sales down 20% year on year. Given stagnation in the eurozone and Japan’s uncertain prospects, a Chinese hard landing would be a big hit to global demand.

Much attention is focused on likely GDP growth this year relative to the government’s 7.5% target. But the bigger issue is whether China can re-balance its economy over the next 2-3 years without suffering a financial crisis and/or a dramatic economic slowdown. Some factors specific to China make this outcome more likely, but success is by no means certain.

Faced with the 2008 financial

crisis, China unleashed a credit boom to maintain output and employment growth. Credit soared from 150% of GDP in 2008 to 250% by mid-2014. Multiple forms of shadow bank credit supplemented rapid growth in bank loans.

The strategy worked, and China continued to create 12-13 million new urban jobs per year. But with investment rising from 40% to 47% of GDP, growth became dangerously unbalanced and heavily dependent on infrastructure construction and real-estate development. Narrowly defined, these activities account for 12% of Chinese value added. In fact, recent research shows that 33% of China’s economic activity relies on the real-

estate sector’s continued health.China is now struggling with a

dilemma common to all advanced credit booms. The longer the boom runs, the greater the danger of wasted investment, huge bad debts, and a major financial crisis. But simply constraining new credit supply and allowing bad loans to default can itself provoke crisis and recession.

This year has been one of seesawing policy responses. The discipline of default has been much discussed, but never quite applied. Despite a significant slowdown, the People’s Bank of China has resisted across-the-board cuts in interest rates or reserve requirements. But, in the second quarter of the

China’s slowdown is the biggest short-term threat to global growth.

China’s Balancing Acte C O n O M i C g R O W T h

RiskMinds magazineJoin @RiskMinds on Twitter a

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year, Premier Li Keqiang reiterated the 7.5% growth target, which was then underpinned by several “targeted” stimulus measures – mainly new lending focused on railways, smaller banks, agriculture, and small businesses. Constraints on the property market, such as limiting multiple purchases or highly leveraged investments, have been tightened and then relaxed.

At least for now, the arguments for constraint and market discipline appear to have won the debate. That may partly reflect a subtle shift in emphasis about the most crucial objective. Recent speeches by both Li and policy experts have downplayed the importance of a specific growth target, focusing instead on job creation and low unemployment.

Fortunately, demographic changes are about to make it easier to re-balance the economy and boost employment enough to avoid social tension. The Chinese working-age population is now slowly shrinking. More dramatically, the number of 15-30 year olds will fall 25% from 2015 to 2025. The rural workforce is still above 300 million, implying that large numbers could still migrate to urban areas. But as the rural workforce ages, the pace of migration will slow.

As a result, China’s labor market will tighten more rapidly than many expect. Rising real wages will support the shift to a more consumption-driven economy,

and declining worries about unemployment will reduce reliance on credit-fueled construction to soak up labor supply.

But the huge debts created by the credit boom remain a major problem. No other economy has ever experienced such a boom and avoided a financial crisis or major growth setback. Optimists often stress two ways in which “China is different.” First, many debts involve different arms of the Chinese state – owed, say, by state-owned enterprises (SOEs) and local governments to state-owned banks.

Second, China’s central government has low debt – only 22% of GDP at the end of 2013 – and thus significant fiscal firepower. With the financial sector facing a large volume of non-performing loans, the government could repeat what it did in the late 1990s, absorbing bad debt and re-capitalizing banks, rather than allowing defaults and bank failures to shock the economy into recession.

But, though China enjoys more room for manoeuvre than other countries facing similar credit booms, the risks remain serious. The bad-loan problem may be most severe among SOEs, but slightly more than half of new business loans since 2010 have been to the private sector, which plays a major role in the troubled property market. And when property booms head south, efforts by companies

and households to deleverage can undermine growth – even if banks are not allowed to fail. A balance-sheet recession does not require a financial crisis.

The more China achieves its stated objective of “a decisive role for the market,” the less the “China is different” argument applies. Interest-rate liberalization would increase borrowing costs for many over-indebted borrowers. A no-bailout rule for shadow banking entities would produce losses that hit confidence. The more the capital account is opened, the more China’s huge debts will be held by banks and other institutional investors around the world.

In an economy with inherited debts equal to 250% of GDP, simply tightening credit supply and imposing market discipline could be a recipe for disaster. Instead, China should use direct fiscal stimulus to offset the deflationary effect of declining credit growth and deleveraging. And it should clean up its banks’ balance sheets through debt write-downs and recapitalization before undertaking full financial liberalization.

China undoubtedly needs to re-balance its economy and introduce more market discipline in its financial system. Demography will give a helping hand with the former challenge. But without careful policy design and sequencing, there could be major setbacks along the way. ■

Lord Adair TurnerLord Adair Turner is a world renowned expert on global economic trends, global finance, macro prudential regulation and the Chinese financial system. Since 2013 he has served as Senior Fellow at the Institute for New Economic Thinking, a new think tank founded by George Soros dedicated to re-thinking the field of economics in the wake of the financial crisis.

involvement at RiskMindsDay One 7:30am CRO Closed Door Breakfast Briefing 09.30am Discussing The New World Order

e C O n O M i C g R O W T h


Managing Risk in the Real World

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Nassim Nicholas TalebNassim Nicholas Taleb, Distinguished Professor Of Risk Engineering, Polytechnic Institute, NEW YORK UNIVERSITY & Author, ‘The Black Swan’ & ‘Antifragile’ Nassim Nicholas Taleb spent 21 years as an option trader before becoming an academic and researcher specializing in mathematical problems with probability and a “real world” approach to risk management.

What do you see as the biggest challenge for managing risk in the real world?We are principally practitioners, which entails a much, much more rigorous approach to risk. Academic love theories, but science isn’t about risk and survival but about what can be proved using a certain set of methods. What cannot be proved is left out.

Put the science where it belongs and know the limits of science beforehand. There are many areas where we take decisions where science cannot help, so it is foolish and UNSCIENTIFIC to be scientific about these things rather than use precautionary heuristics.

So our job is to formalize a set of rules and heuristics with clearly defined things. Before SILENT RISK nobody tried Bourbaki-style to formalize risk management by making everything clearly and explicitly defined and stating what can and what cannot be captured by “models” and what a payoff means.

Risk is not science, it is not practice, it is not probability, it is not economics, it is not statistics. Risk is RISK, a discipline on its own, with its own rigor. As a discipline it is formalization, Urgently. So my project — both real-world and anti-anecdotal — is inspired of the many historical efforts and projects aimed to instill rigor in domains that grew organically in a confused way, by starting from the basics and expanding, Bourbaki-style, in a self-contained manner but aiming at maximal possible rigor. This would be a Bourbaki approach but completely aiming at putting the practical before the theoretical, a real-world rigor (as opposed to Bourbaki’s scorn of the practical and useful, justified in a theoretical field like mathematics).[Note BOURBAKI was a group of French mathematicians who rebuilt mathematics on formal bases.]

Who do you most respect in the risk management community currently?To be honest, only the decision makers who emphasize that we need to worry about ruin probabilities not just variations. The blowup risk needs to be zero, otherwise the system is not sustainable. In business the chairman of Goldman Sachs said that. Same with . Among practitioners-mathematicians, Ed Thorp is the most sophisticated.

What are you reading at the moment?Russian material in probability. Some classics, and I am scouring legal theory to see how historically the scholastics defined and dealt with risk: lawyers were very sophisticated, ahead of mathematicians.

Financial crises are as old as the pyramids- there is nothing we can do to stop them. Do you agree? Certainly. But we have known since Babylon what makes systems survive crises.

What are you most looking forward to about hosting the real world risk management workshop at RiskMinds?The atmosphere and feeling that people want rigor. ■

involvement at RiskMindsDay Three Thursday 11th December 201409.50 am Risks In The Real World

10.10am Model Risk In The Real World: A Discussion

Day Four Friday 12th December 2014 9.00am - 5.00pm

Workshop: Risk Management In The Real World

R i S K M O D e L L i n g


9Our exciting multi-disciplinary research project

brings together expertise in financial risk management and organisational psychology.

Using the Macquarie University Risk Culture ScaleTM we have examined risk culture in 113 business units across three major banks with multinational operations. This scale is the first statistically-validated survey instrument for assessing risk culture in financial institutions. It assesses culture on four key dimensions of which three are desirable and one (Avoidance) is undesirable.

At Riskminds we will be able to discuss some of our findings to date:

Strong risk culture (higher scores for Valued, Proactive, Manager and low scores for Avoidance) was generally associated with more desirable risk-related behavior (e.g. speaking up) and less undesirable behavior (e.g.

manipulating controls). This finding provides further validation of the importance of risk culture generally, and of the Macquarie University Risk Culture Scale as a means of assessing risk culture.

There are statistically significant differences between the risk cultures of the three large banks we have analysed. That is, we can rank them meaningfully in terms of the average risk culture scores. This average comparison may be misleading, however, because variations exist within each of the three banks.

Most variation in risk culture scores occurs at the business unit level and seems to be driven by the local team environment. This is consistent with the hypothesis that culture is a local construct and very much dependent on interactions with close colleagues and the immediate manager. ■

involvement at RiskMindsDay Four Wednesday 10th December 2014 9:10am Measuring Risk Culture – Interactive Risk Discussion 2:25pm Assessing Risk Culture

Elizabeth SheedyElizabeth Sheedy - Prior to joining the university Elizabeth worked for Macquarie Bank and Westpac where she gained insights into the structure and culture of financial institutions. She now teaches courses in Financial Risk Management and Modelling Market Risk at Macquarie University.

Managing Risk in the Real World

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Technically, the new reforms are a masterpiece for corseting the banking industry;

Unfortunately, they miss two critical components which will make them at best inefficient in the long run: They ignore the ability of banks to improve their service to the economy, and the massive interactions they have with the rest of the economy.

The value of banks to the economy comes from their ability to reallocate available funds to actors who need financing; consequently, their expertise in assessing the solvency of these actors is at the core of banks “raison d’être”. But for years now, regulators have pushed banks risk management towards using the same sterilized models (pillar1) with simplistic assumptions: one-factor models for easy summation, ignoring sovereign risk, long term maturities, funding issues, etc. The internal models (pillar2) were supposed to

override these inefficiencies. But they became corrupted because the supervisors used their insights to raise the minimum capital requirements imposed on individual banks (SREP). As a result, internal models worked out to assess best risk estimates were progressively skewed to reduce capital requirements. So banks are loosing their ability to assess risks properly!

Dexia, a dying nonetheless historically hyper-compliant bank, is a good example of an institution which has confidently perverted its business model while remaining regulatory compliant. With a Tier1 ratio at 21,4% and a share value of 0,03€ at the end of 2013, it also clarifies the limits of the regulatory framework.

Another unchallenged weakness of the new reforms is that it considers the banks as a closed system. But at a given point in time, there is a finite amount of available capital

in the economy; if a larger share is allocated to banks, a smaller remains for the rest of the economy, making it more fragile. And as the balance sheets of banks are the mirror of the rest of the economy (what we have is what the banks owe us, and reciprocally), an increased vulnerability of the economy weakens banks. Indeed, macro-prudential regulators are raising the alarm over banks over-capitalization, but micro-prudential regulators still promote higher capital requirements.

What are the solutions? A major first step would be to reinstate banks and regulators in their natural roles: Banks should be allowed to assess their own risks, and regulators to rule depositor’s protection and fair competition. A precondition is the termination of moral hazard: if a bank defaults, only the shareholders should suffer, not the depositors or the taxpayer. This is the priority. ■

Would the new reforms have saved Dexia?

Jean-Bernard CaenJean-Bernard Caen - Since early 2014, Jean-Bernard has been working as an industry expert and Institutional Advisor, working on assignments related to risk and regulation. Previously he was at Dexia from 2002 to 2013, as Head of Economic Capital and Strategy and later on as Risk Senior Advisor.

involvement at RiskMindsDay Three Thursday 11th December 2014 4.55pm Dexia Case Study

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Leveraging our extensive expertise of business, finance and risk modelling, Ares & Co offers clients distinctive quantitative solutions to alleviate their concerns about

Shaping new strategies in the financial services industry

Ares & Co is a strategy consulting boutique working with leading financial institutions andregulators throughout Europe. The firm has a particular focus on risk management and theimpact of regulation on bank and insurance company balance sheets, capital requirements,and business models. Helping clients adapt their strategies in light of the wave of newregulation brought on by the financial crisis is Ares & Co’s core activity.

London – Luxembourg - Pariswww.aresandco.com

time and money


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Behavioral Economics, One of the hottest topics in finance and economics for the past

two decades has been Behavioral Economics, a field that originated in the research of Daniel Kahneman and Amos Tversky. Tversky died in 1996, and Kahneman was awarded The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel in 2002. The Nobel committee cited their joint work on “prospect theory as an alternative, that better accounts for observed behavior” of humans making decisions “when future consequences are uncertain” (aren’t they always?).

Classical financial modeling assumes that people make decisions in a cold-blooded utilitarian way that is therefore susceptible to mathematics and statistics. Kahneman and Tversky (K&T) cataloged a collection of irrational warm-blooded peculiarities in the way people choose between alternative bets on their own potential profits and losses when playing games of chance. Here are two of their many discoveries: (i) people are found to dislike the probability of losing $5 more than they like the equal probability of winning $5; and (ii) people typically underestimate the likely occurrence of rare (“black swan”) events.

In essence, claim K&T, people are psychologically inept at making

rational decisions in games of chance.Not everyone agrees with K&T.

Real life is not always a game of chance; while the probability of throwing heads and tails is known exactly, the probability of human behavior is not. Animate individuals are driven by motives that can defy statistics. Our legal system recognizes this, and finds defendants guilty or innocent not on the basis of statistical evidence but on the basis of judgment and believability. You can find some criticism of K&T’s approach in an interesting article by Professor Alex Stein (“ARE PEOPLE PROBABILISTICALLY CHALLENGED?” to appear in the Michigan Law Review in 2013.) Prospect Theory

But put these criticisms aside for now and accept K&T’s proof that people are bad at making rational decisions. Proceeding from there, K&T developed what they call prospect theory. In prospect theory, as opposed to classical economic theory, K&T replaced homo economicus’s rational notions of losses and gains and their probabilities by the empirically determined “irrational” values used by everyday fearful and greedy hot-blooded homo affectus.

Classical economic theory was elegant but flawed, and prospect theory was a beautiful idea/ideal that aimed to fix it by taking account

of actual human preferences in determining economic value.

Unfortunately, that isn’t what happened. The ambitions of prospect theory as a science of human behavior foundered in a maelstrom of increasing mathematical complexity, and interest has faded. Instead behavioral economics has taken two less quantitative directions. First, academics now use the cover of behavioral economics to write papers on all sorts of irrelevant apparent irrationalities. Second, the part of behavioral economics that has flourished enormously is the notion that people are probabilistically challenged, and that it requires governments and agencies, helped by academics, to nudge people into doing what is “good” for them. Let me illustrate.

Some strange interests of behavioral finance Research in behavioral finance has taken a strange byway, devoted more to “psychology” rather than finance. Here are some titles and excerpts from abstracts of recent research papers from a newsletter I subscribe to. I’ve omitted author names but you can find the papers on ssrn.com:

The Financial Psychology of Worry and Women (“… the emerging

Misbehavioural Psychology

This is my tale of disappointment, of ground breaking research gone awry and then embraced as a tool for political manipulation.

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Emanuel Derman Emanuel Derman is Co-Head of Risk at Prisma Capital Partners and a professor at Columbia University, where he directs their program in financial engineering.

involvement at RiskMindsDay Three Thursday 11th December 2014 9.45am Guest Quantitative Perspective New Systemic Risks: Governments, Corporations, Data, Advertising, Money & Models 10:10am Model Risk In The Real World: A Discussion

hypothesis that researchers should explore is (that) women reveal greater degrees of worry than their male counterparts for … financial services and investment products.)

Sports Sentiment and Stock Returns (“We find a significant market decline after soccer losses.”)

Who Cares About Stock Market Booms and Busts? Evidence from Data on Mental Health. (“We present evidence that the level, 6 month and yearly changes in the share price index are associated with better mental health …”

Would Women Leaders Have Prevented the Global Financial Crisis? Implications for Teaching about Gender, Behavior, and Economics.

Self-Esteem, Shame and Personal Motivation (“Overconfidence and high sensitivity to shame emerge as substitute mechanisms to induce efficient decisions.”)

Willpower and the Optimal Control of Visceral Urges (“We investigate the behavior of an agent who optimally consumes a cake … over time and who recognizes that restraining his consumption too much would exhaust his willpower”)

Grapes of Wrath: The Angry Effects of Self Control (“We find that exerting self control is associated with angry behavior more broadly.”)

Is this stuff seriously related to business and finance, and is it

useful, or is it just a self-indulgent form of grant and tenure getting?

Paternalistic Command & Control

And now for the worst part, which I illustrate using a 2011 column by an economics columnist in Australia I stumbled across. She interviewed Kahneman and then wrote:

“Kahneman says we can use this knowledge about our irrationality to influence public policy. We should make it so people have to opt out of things we find socially desirable and opt in to things we think undesirable. Innate inertia will do the rest.”

Notice that there is a glib assumption in her use of “we” and “people.” I emailed her: “Who is the ‘we’ that will determine what is socially desirable and who are the ‘people’ that will do the opting?”

To which she replied that “we” are the policy engineers, and then asked me (rhetorically?): “Isn’t that the way democracy works?”

I don’t think so. This reminds me more of the sleep-teaching of the Betas in Brave New World: “Alpha children wear grey. They work much harder than we do, because they’re so frightfully clever. I’m awfully glad I’m a Beta, because I don’t work so hard. And then we are much better than the Gammas and Deltas. Gammas

are stupid. They all wear green, and Delta children wear khaki. Oh no, I don’t want to play with Delta children. And Epsilons are still worse. They’re too stupid to be able to read or write. Besides they wear black, which is such a beastly color. I’m so glad I’m a Beta.”

Along similar lines, consider Richard Thaler, a Chicago academic who has been an influential and early researcher in behavioral finance and is also the co-author of Nudge, a book he says is about “enlisting the science of choice to make life easier for people and by gentling nudging them in directions that will make their lives better.”

Thaler is, according to a recent news article part of a so-called Dream Team “consortium of behavioral scientists” working for Obama “to help their favored candidate in the 2012 presidential election.” Among other activities, they “suggested how to characterize the Republican opponent, Mitt Romney, in advertisements.”

It’s remarkable that behavioral economics has evolved from a field of study into a tool for manipulating people, not only using the Big Data of Amazon and Google, but also in politics and government.

This is not government of the people by the people for the people. I think I’d rather be forced than nudged. At least then the battle lines are clearer. ■

b e h a v i O u R a L e C O n O M i C S


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The Illusion of the Irrelevance of the Long Term

In the early 80’s a riddle did the rounds which had everyone stumped for a few days until the solution followed shortly afterwards. Considering this was before you could forward something to a group in Outlook, ideas used to propagate themselves very quickly in those days. The riddle went like this:

Three men go into a motel, the man behind the desk said the room is thirty dollars.

So each man paid ten dollars and went to the room.

A while later the man behind the desk realised the room was only twenty five dollars, So he sent the bellboy to the three guys room with five dollars.

On the way to the room the bell boy couldn't figure out how to split the five dollars evenly with the three men so he gave them each one dollar and kept the other two dollars for himself.

This meant that the three men each paid nine dollars for the room, which is a total of twenty seven dollars.

Add the two dollars that the bell boy kept, it equals to twenty nine dollars, where is the other dollar?

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The answer – which I must confess eluded me for ages – is that there is no $30. Each man pays $9 for the room which equals $27, plus the $2 equals $29. Simple. But the illusion is a powerful one.

In the same way, the powerful illusion is that every decision we make is important and that we never get the chance – like a share trader who makes dozens of trades a day, or the poker player who plays dozens of hands an evening – to get to the medium term. But we do.

No poker player gets to play any exact hand more than once. But you still make the decision that is right according to the Long Term every time, and that way you make a profit. No trader gets to invest in the exact same share with the exact same future prospects for the exact same price twice. But by investing with the best long term expectation in a series of inherently independent situations you give yourself the best chance of making the best Long Term return.

I understand that some decisions feel so big that we’ll never ever reach any kind of long term and so the best policy seems to be to play it safe. Putting your children through school; setting up your own business; buying your own home; getting married; going back into training; getting divorced; being completely honest

with your team… the list is endless. And that’s the point.While we look at the present and the future from

one position at the point of making a decision… it all looks very different in the rear view mirror. Eventually the numinous truth of the illusion catches up with us and we realise that each monumental mountain was really only a molehill – only one of many problems that we had to overcome; just part of a continuum which eventually became a Long Run.

And those of us who explored the opportunities and took the risks in a calculated way will, eventually, have received what we expected (or Expected) and deserved. And those of us who eschewed them and feigned satisfaction with the safer option experience a pain much greater than the pain of setback or Short Term failure… in the Long Run they experience the agony of regret.

And the most amazing thing about it all? The most amazing thing is that we know this. That’s why when we have to make a difficult decision we feel torn… we feel torn between the person we are now and the person we know deep down that we’ll become in time. And that is the struggle that takes place inside us all whenever we make a decision. Long Term vs Short Term: the us we are tonight and the us we’ll be tomorrow. ■

You can read more of Caspar's work by visiting his website:

risksanddecisions.com

Caspar BerryCaspar Berry is a professional risk taker. He has had a roller coaster of successful and diverse careers starting with Economics and Anthropology at Cambridge University followed by Screenwriter, Professional Poker Player and Digital Media Entrepreneur.

involvement at RiskMindsDay TwoWednesday 10th December 2014 10:30 Guest Poker Guru Address Counter/IntuitiveRisk Taking & Decision Making In Poker, Business & Life

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We have recently returned to interest rate modeling focusing on three projects.

The first project is concerned with generalizing our trinomial tree-building procedure so that the model used does not have to have the form in equation (1). Specifically we show how a trinomial tree for the short rate can be built for almost any assumption about the process followed by r. Research by Deguillaume et al (2013) using historical data suggests that the short rate is lognormal for low rates (between about 0% and 1.5%), normal for moderate rates (between about 1.5% and 6%), and roughly lognormal for higher rates. We show that prices in the market are consistent with this type of volatility

function and a mean reverting drift for the short rate. See Hull and White (2014).

The second project is concerned with OIS discounting. We examine the effect of the move from LIBOR discounting to OIS discounting on the pricing of interest rate derivatives distinguishing between a pure discounting effect and the effect on forward rates. We also consider how non-standard derivatives that provide a payoff dependent on LIBOR can be valued. When LIBOR discounting is used, it is sufficient to build a tree depicting the behaviour of the LIBOR rate. When OIS discounting is used, it is necessary to know about the behaviour of both the OIS rate and the LIBOR rate. We show that

a three-dimensional tree is not necessary. It is sufficient to build a tree for the OIS rate and calculate the expected value of the relevant LIBOR rate at each node. See Hull and White (2015)

The third project (joint with Alexander Sokol) is concerned with developing a real world process for interest rates. This is important for some scenario analysis and stress testing applications. Other research in this area has estimated a market price of interest rate risk that is consistent with the average slope of the short end of the term structure. We look at the average slope at all maturities and reach conclusions about reasonable assumptions for the market price of risk. See Hull, Sokol, and White (2014). ■

Interest Rate ModelingAlan White and I did a lot of research on interest rate modelling in the 1990s. We developed what have become known as the Hull-White one-factor and two-factor short rate models and showed how a tree for the short rate can be constructed for the situation

dx = {0 (t) - ax } dt + odzwhere x is some function of the short rate r, a and are positive constants, and 0 is a function of time chosen so that the model fits the current term structure.

John HullJohn Hull is an internationally recognized authority on derivatives and risk management and has over 50 publications in this area.

involvement at RiskMindsDay ThreeThursday 11th December 2014 3:20pm Interest Rate ModelingModelling Interest Rates in theCurrent Low Interest Environment

Day Four Friday 12th December 2014 9.00-5.00pm Workshop: Credit Risk: Theory And Practice

References: DeGuillaume, Nick, Riccardo Rebonato, and Andrei Pogudin (2013), “The Nature of the Dependence of the Magnitude of Rate Moves on the Level of Rates: A Universal Relationship,” Quantitative Finance, 13, 3, pp. 351-367. Hull, John and Alan White “ A Generalized Procedure for Building Trees for the Short Rate and its Application to Determining Market Implied Volatility Functions,” forthcoming, Quantitative Finance, 2014 Hull, John and Alan White, “OIS Discounting, Interest Rate Derivatives, and the Modeling of stochastic interest rate spreads” forthcoming, Journal Of Investment Management, 2015 Hull, John, Alexander Sokol, and Alan White, “Short Rate Joint Measure Models,” Risk, October 2014.

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Didier SornetteDidier Sornette is professor of Entrepreneurial Risks in the department of management, Technology and Economics at the Swiss Federal Institute of Technology (ETH Zurich). He is also the author of 7 books.

involvement at RiskMindsDay TwoWednesday 10th December 2014 8.30am The Outlook For Financial Bubbles Determining The Possible Economic & Financial Bubbles How Can Risk Managers Spot The Signs and Manage The Symptoms Before The Bubbles Pop?

Using the mechanics of creep in material sciences as a metaphor, we propose a

general framework to understand the evolution of financial, economic and social systems and to outline visions for the future. In a nutshell, highly non-linear out-of-equilibrium open systems tend to exhibit a long phase of slow apparent stable evolution, which are nothing but slow maturations towards instabilities, failures and changes of regimes. This framework

emphasises the endogenous nature of the system organisation towards crises, in which exogenous perturbations may just act as triggers when the system is ripe, if at all. Based on a wealth of examples from history where a small event had a cataclysmic consequence, we propose a novel view of the current state of the world, avoiding the traps of an illusionary stability and simple linear extrapolation. Self-organised cooperative structures may

catalyse macroscopic emerging structures that are resilient to stressors. The key insight is that nonlinear

processes, like creep, not only explain disintegration and collapse, but that they also are fundamental mechanisms that lead to structure and growth. In the end, global, systemic and multifaceted problems are likely to come to convergence in the following

decades. But creativity, discoveries, success, value generation, life… will end up winning… somewhere in the available landscape, not at all uniformly and equally, but thrive nevertheless.

This provides the platform for making sense of the bubbles that permeate financial markets, which have been and are still the subject to debate and controversy. They are in general not well understood and are hardly ever characterised specifically, especially ex ante. We define a bubble as a period of unsustainable growth, when the price of an asset increases ever more quickly, in a series of accelerating phases of corrections and rebounds. More technically, during a bubble phase, the price follows a faster-than-exponential power law growth process, often accompanied

by log-periodic oscillations. This dynamic ends abruptly in a change of regime that may be a crash or a substantial correction. The mechanism behind financial bubbles and their log-periodic

power law signatures emerges spontaneously from the complex system that financial markets are as a consequence of feedback mechanisms, hierarchical structure and specific trading dynamics and investment styles. We argue that the risk of a major correction, or even a crash, becomes substantial when a bubble develops towards maturity, and that it is therefore very important to find evidence of bubbles and to follow their development from as early a stage as possible. We call for the establishment of Financial Crisis Observatories, like the FCO at the ETH Zurich, where financial markets can be monitored continuously for potential systemic risk and where both generally accepted as well as innovative tools and models can be tested and challenged in a systematic scientific way. ■

A Creepy Bubbling World

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Interview With Professor Damiano Brigo

What areas are you looking at for your new research and why?

I keep working on global valuation, meaning valuation inclusive of credit, collateral, margining and funding costs. This can be done both in presence of CCPs or standard CSA. One of the main challenges is that under a fully rigorous analysis the pricing probability measure becomes deal dependent. Equivalently, we could say that the pricing operator becomes nonlinear. This leads to researching mathematical methods for nonlinear PDEs or Backward SDEs. There are strong theoretical, computational but also operational challenges. Mostly, this requires a holistic way of thinking about risk and valuation, with valuation becoming aggregation-dependent. I am also working on liquidity risk more in a risk management contest. In that area, we had a paper in 2010 suggesting stochastic holding period models in traditional risk measures. The industry has shown considerable interest, but we need to work out the calibration of the holding period dynamics. I am finally working on a number of problems in Optimal trade execution and dynamics of dependence. Dynamics of dependence is still an underdeveloped area in the financial modeling literature. Overall the key new aspect is that all areas are becoming more and more interconnected.

What are the most important recent breakthroughs in quantitative finance?

To be honest I have not seen really any major breakthrough in the last few years. The investment banking industry is still in a very defensive position, worrying a lot about costs and adjustments, and this may explain why innovation on the active side has slowed down. Rather than creating new exotic products and deal with those in a way that neglects a number of important risks, the industry is now focusing on simpler products but trying to manage them with complex risks. This is not an easier task compared to the earlier picture, if anything it is much more difficult. People sneering at research in funding costs, for example, have not realized the complexity and nonlinearities this implies. What I do see is a patient and progressing work to update methodology for risk and valuation. Colleagues are re-discovering past research results that are becoming more important now. For example, and related to what I mentioned earlier, the realization that asymmetric funding costs and replacement closeout at default may lead to non-linear pricing operators has been an important one. Asymmetric borrowing and lending rates in relation with hedging strategies had been analyzed in an advanced technical setup via here

involvement at RiskMindsDay ThreeThursday 11th December 2014 2:45pm Initial & Variation Margins

Professor Damiano BrigoProf. Damiano Brigo is Chair and co-Head of Mathematical Finance at Imperial College London, consistently ranked among the top 10 world universities, and Director of the Capco Research Institute. Formerly Gilbart Professor at King’s and Managing Director of Fitch, Damiano published 70+ works in Mathematical Finance,

credit, initial and variation margins, hedge funding costs and multiple interest-rate curves are all included, something we could call “coherent post 2007-2008 financial modeling for valuation” if we had to come up with a short description. Do you feel the role of Quants has changed? Where do you see your PhD students ending up?

For sure Quants need to be more eclectic now. They are requested to learn several aspects of regulation, bank policy, treasury bank model, risk control, overall funding and hedging strategy, what happens at default, collateral documentation, and similar areas that we could name ``broader picture”. I occasionally express this with a provocative expression by saying that we are witnessing the end of platonic pricing and of platonic financial modeling. Of course it has always been like that to some extent, but now this is more and more impoerant. As valuation is now aggregation dependent, nonlinear, related to the margining

procedure, credit situation of institutions involved in the trade, funding policy of the treasury, boundary conditions assumed at default, and a number of other factors beyond the single equivalent martingale measure setting, the Quantitative analyst should not feel that since she has a PhD in stochastic analysis of perhaps Pure Maths/Physics she can afford to ignore the ``broader picture” areas I mentioned earlier. That is impacting valuation and risk and we had better look at this without methodology silos. We definitely need a more holistic approach, which is clearly much more challenging. This has been happening for a while really but now it is becoming more and more relevant, at least under a rigorous approach. Overall I think that PhD students facing the industry now and aspiring to become “Quants” will have to be more eclectic than their counterparts of say 10-15 years ago. They will find that even for specialized front office jobs the ``broader picture” is important, and that most roles available will be on the risk side, probably. Their career opportunities might be overall slower than in the old days, but there is still considerable work to do. ■

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"To be honest I have not seen really any major breakthrough in the last few years."


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References: [1] A. Tacchella, M. Cristelli, G. Caldarelli, A. Gabrielli and L. Pietronero: A New Metrics for Countries’ Fitness and Products’ Complexity, Nature: Scientific Reports, 2-723 (2012) [2] M. Cristelli, A. Gabrielli, A. Tacchella, G. Caldarelli and L. Pietronero: Measuring the Intangibles: A Metrics for the Economic Complexity of Countries and Products, PLOS One Vol. 8, e70726 (2013)Management, 2015 Hull, John, Alexander Sokol, and Alan White, “Short Rate Joint Measure Models,” Risk, October 2014.

Economic Complexity refers to a new line of research which portrays economic growth as a

process of evolution of ecosystems of technologies and industrial capabilities. Complex systems analysis, simulation, systems science methods, and big data capabilities offer new opportunities to empirically map technology and capability ecosystems of countries and industrial sectors, analyse their structure, understand their dynamics and measure economic complexity. This approach provides a new vision of a data driven fundamental economics in a strongly connected, globalised world. In particular here we discuss the COMTRADE dataset which provides the matrix of countries and their exported products. According to the standard economic theory the specialization of countries towards certain specific products should be optimal. The observed data show that this is not the case and that diversification is actually more

important. Specialization may be the leading effect in a static situation but the strongly dynamical globalized world market suggests instead that flexibility and adaptability are essential elements of competitiveness as in bio-systems. The situation is different for individual companies or sectors which seem instead to specialize only on few products. The crucial challenge is then how to turn these qualitative observations into quantitative variables. We have introduced a new metrics for the Fitness of countries and the Complexity of products which corresponds to the fixed point of the iteration of two nonlinear coupled equations. The nonlinearity is crucial because it represents the fact that the upper bound on the Complexity of a product is given by the less developed country that can produce it. The information provided by the new metrics can be used in various ways. The direct comparison of the Fitness with the country GDP

gives an assessment of the non-expressed potential of the country. This can be used as a predictor of GDP evolution or stock index and sectors perfomances. This implies also an assessment of the Risk. In addition it can be used as a strategic guide for industrial policy and the possible exit from the poverty trap.The global dynamics shows a large degree of heterogeneity which implies that countries which are in a certain zone of the parameter space evolve in a predictable way while others show a chaotic behaviour. This heterogeneous dynamics is also outside the usual economic concepts. When dealing with heterogeneous systems, in fact, the usual tools of linear regressions become of inappropriate. Making reliable predictions of growth in the context of economic complexity will then require a paradigm shift in order to catch the information contained in the complex dynamic patterns observed. ■

Luciano PietroneroLuciano Pietronero studied physics in Rome and was a research scientist at Xerox Webster and Brown Boveri until 1983. He then moved to Groningen, where he was professor in condensed matter theory (1983-87). Since 1987 he is professor of physics at the University of Rome “Sapienza”.

Measuring The IntangiblesA New Metric for the Economic Complexity

of Countries and Products Luciano Pietronero - University of Rome Sapienza

and Institute of Complex Systems CNR, Italy

involvement at RiskMindsDay OneTuesday 9th December 2014 11:50am Technical Lecture: Measuring The Intangibles

Coaches will leave Hotel Okura from 18.00 and from the Tobacco Theatre at 20.30

no invite needed for this event as it is very casual

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Welcome Drinks ReceptionMonday 8th December

Heian Room,Hotel Okura, Amsterdam

18:15 – 20:30

Drinks ReceptionWednesday 10th December

Tobacco Theatre, Nes 75 – 87, 1012 KD Amsterdam

18:15 – 20:30

Casino NightTuesday 9th December

Heian Room,Hotel Okura, Amsterdam

18:15 – 20:30


Meet the team

Luke Raphael Head of Sponsorship

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Rustum Bharucha Business Development Manager

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Amos Rojter Head of Digital Media

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Lauren Sheppard VIP Relationship [email protected]

Rachel LewisSenior Client Liaison [email protected]

Rachel BoLogistics Manager

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Victoria ChattertonConference Director

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Rachel NobleMarketing Manager

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Future Events

The 4th AnnualRiskMinds Insurance16 - 20 March 2015Hotel Okura, Amsterdam

The 5th AnnualRiskMinds AmericasJune 2015JW Marriott Marquis Miami

RiskMinds Risk & Financial Regulation ForumJune 2015Venue To Be Confirmed

RiskMinds AsiaNovember 2015Venue To Be Confirmed

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