Market Consistency: Model calibration in imperfect markets »

Malcolm Kemp is a well known actuary and expert in risk and quantitative finance, with over 25 years’ experience in the financial services industry. From 1996 to 2009 he was Head of Quantitative Research at a leading UK investment management business and before that was a partner in an actuarial consultancy. He is currently Managing Director of Nematrian Limited.

"This is a very timely book that will repay careful reading, and help to develop insurance companies' and model designers' thinking in the run-up to the implementation of Solvency II. Many tricky topics are covered in a helpful and clear way, which can only improve the quality of communication between the actuarial and accounting professions."

Kathryn Morgan, Fellow of the Institute of Actuaries

"Malcolm Kemp has done a great job - he has put together views from different perspectives, in an excellent and comprehensive way. This book provides big and important support for actuarial practitioners, and certainly for other mathematical professions as well."

Christoph Krischanitz, President of the Actuarial Association of Austria and Chairman of WG "Market Consistency" Groupe Consultatif Actuariel Europeen

"This is a timely and learned book on a highly topical subject and contains many valuable insights. The scope is wide-ranging, providing an overarching framework for the ‘principles and practices of market consistency’ and showing clearly how different elements of financial practice fit together within this framework. There is recognition that markets rarely exhibit all the qualities needed to make the application of market consistency straightforward and clear guidance on how to combine market information with reasoned judgement. This book should make a significant contribution to the debate on the use of market consistency and to improving the quality of market consistent valuations derived in practice."

Colin Wilson, Head of Investment & Risk, Government Actuary's Department

"The financial world more than ever needs clarity of communication in setting business strategy, enterprise risk management, regulatory supervision and more generally in providing advice to Board Directors and senior management. Through Market Consistency Malcolm Kemp has brought together great clarity in developing a rigorous framework of well-defined terms, concepts and principles. The book is structured to be of value to practitioners in advanced finance as well as financial practitioners who are less mathematically inclined. Large parts of the book should be essential reading for Board Directors responsible for their organisation’s enterprise risk management, and equally for financial practitioners advising those Directors."

Tony Hewitt, Programme Director, MSc Actuarial Finance, Imperial College Business School

"The recent liquidity crisis has led many to call into question market consistent methods. In this comprehensive and accessible account the author successfully addresses the challenges posed to both the theoretical justification for and practical application of such approaches across a range of disciplines."

Paul Fulcher, Managing Director, Risk Advisory, UBS Investment Bank

Preface.

Acknowledgements.

Abbreviations.

Notation.

1 Introduction.

1.1 Market consistency.

1.2 The primacy of the ‘market.

1.3 Calibrating to the ‘market’.

1.4 Structure of the book.

1.5 Terminology.

2 When is and when isn’t Market Consistency Appropriate?

2.1 Introduction.

2.2 Drawing lessons from the characteristics of money itself.

2.3 Regulatory drivers favouring market consistent valuations.

2.4 Underlying theoretical attractions of market consistent valuations.

2.5 Reasons why some people reject market consistency.

2.6 Market making versus position-taking.

2.7 Contracts that include discretionary elements.

2.8 Valuation and regulation.

2.9 Marking-to-market versus marking-to-model.

2.10 Rational behaviour?

3 Different Meanings given to ‘Market Consistent Valuations’.

3.1 Introduction.

3.2 The underlying purpose of a valuation.

3.3 The importance of the ‘marginal’ trade.

3.4 Different definitions used by different standards setters.

3.5 Interpretations used by other commentators.

4 Derivative Pricing Theory.

4.1 Introduction.

4.2 The principle of no arbitrage.

4.3 Lattices, martingales and Îto calculus.

4.4 Calibration of pricing algorithms.

4.5 Jumps, stochastic volatility and market frictions.

4.6 Equity, commodity and currency derivatives.

4.7 Interest rate derivatives.

4.8 Credit derivatives.

4.9 Volatility derivatives.

4.10 Hybrid instruments.

4.11 Monte Carlo techniques.

4.12 Weighted Monte Carlo and analytical analogues.

4.13 Further comments on calibration.

5 The Risk-free Rate.

5.1 Introduction.

5.2 What do we mean by ‘risk-free’?

5.3 Choosing between possible meanings of ‘risk-free’.

6 Liquidity Theory.

6.1 Introduction.

6.2 Market experience.

6.3 Lessons to draw from market experience.

6.4 General principles.

6.5 Exactly what is liquidity?

6.6 Liquidity of pooled funds.

6.7 Losing control.

7 Risk Measurement Theory.

7.1 Introduction.

7.2 Instrument-specific risk measures.

7.3 Portfolio risk measures.

7.4 Time series-based risk models.

7.5 Inherent data limitations applicable to time series-based risk models.

7.6 Credit risk modelling.

7.7 Risk attribution.

7.8 Stress testing.

8 Capital Adequacy.

8.1 Introduction.

8.2 Financial stability.

8.3 Banking.

8.4 Insurance.

8.5 Pension funds.

8.6 Different types of capital.

9 Calibrating Risk Statistics to Perceived ‘Real World’ Distributions.

9.1 Introduction.

9.2 Referring to market values.

9.3 Backtesting.

9.4 Fitting observed distributional forms.

9.5 Fat-tailed behaviour in individual return series.

9.6 Fat-tailed behaviour in multiple return series.

10 Calibrating Risk Statistics to ‘Market Implied’ Distributions.

10.1 Introduction.

10.2 Market implied risk modelling.

10.3 Fully market consistent risk measurement in practice.

11 Avoiding Undue Pro-cyclicality in Regulatory Frameworks.

11.1 Introduction.

11.2 The 2007-09 credit crisis.

11.3 Underwriting of failures.

11.4 Possible pro-cyclicality in regulatory frameworks.

11.5 Re-expressing capital adequacy in a market consistent framework.

11.6 Discount rates.

11.7 Pro-cyclicality in Solvency II.

11.8 Incentive arrangements. 

11.9 Systemic impacts of pension fund valuations.

11.10 Sovereign default risk.

12 Portfolio Construction.

12.1 Introduction.

12.2 Risk-return optimisation.

12.3 Other portfolio construction styles.

12.4 Risk budgeting.

12.5 Reverse optimisation and implied view analysis.

12.6 Calibrating portfolio construction techniques to the market.

12.7 Catering better for non-normality in return distributions.

12.8 Robust optimisation.

12.9 Taking due account other investors’ risk preferences.

13 Calibrating Valuations to the Market.

13.1 Introduction.

13.2 Price formation and price discovery.

13.3 Market consistent asset valuations.

13.4 Market consistent liability valuations.

13.5 Market consistent embedded values.

13.6 Solvency add-ons.

13.7 Defined benefit pension liabilities.

13.8 Unit pricing.

14 The Final Word. 

14.1 Conclusions.

14.2 Market consistent principles. 

Bibliography.

Index.