Equity-Based Insurance Guarantees Conference June 18, 2012 Tokyo, Japan

Market Risk Modeling

Eric Yau

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Market Risk Modeling

Eric Yau Consultant, Barrie & Hibbert Asia Eric.Yau@barrhibb.com 18 June 2012 (1150 1230 hours)

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Agenda
+ VA market risk modeling: motivation and building blocks + Calibrating to the Japan market + Risk factor modeling
Interest rate Equity Credit

+ Hedging and hedge projection

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VA market risk modeling: motivation and building blocks

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Motivation of VA modeling
VA modeling aims to answer a few fundamental questions:

Product Design / Pricing

What is the cost of guarantees embedded in VA? How do product features impact this cost?

What is the right level of reserve? How hedging strategies g affect reserves?

How do different risk management strategies affect cashflow profile?

Valuation

Hedging

How should we implement a hedging strategy and test its effectiveness? 4

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Building blocks of VA modeling

Economic Assumption Model Assumption Model Choice Market Data

Risk Monitoring Reports: calibration * Asset and liability valuation * Mismatch position * Risk limits and utilization

Economic Scenario Generator

Economic scenarios: Base and Sensitivities

Trading System
Liability Portfolio

ALM System

Asset Portfolio

Generate, for both asset and liability portfolios: * Valuation * Greeks * Mismatch position

Asset Portfolio Optimizer

Calculation Engine

Trading Engine

* Hedge Strategy * Rebalancing Rules * Risk Limits *A Available il bl Instruments

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VA risk management and modeling

Product design and pricing - Cost of guarantees - Sensitivity S iti it analysis l i Valuation - Reserve/capital calculation - Reserve R projection j ti

Ensure fair and adequate pricing / valuation / capital Internal hedging - Greeks calculation - Automated calibration Hedge projection - Projection of hedges - Variance reduction

Capture key risk exposure of hedging strategy

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Desirable ESG features for VA

+ Integrated modeling
Interest rates, multiple equity indices, credit risks and alternative assets Consistent C i t t market-consistent k t i t t and d real-world l ld modeling d li

+ Multiple equity modeling choices

E.g., Local volatility, Heston with jumps, to support analysis of model risk

+ Accuracy
Exact fit to starting yield curve (for interest rate models) Accurate fit to option-implied volatility

And for hedging: + Ability to be run on efficient hardware configurations

Grid-enabled; Access to ESG capabilities without the need to use the ESG interface

+ Fast calibration tools to facilitate re-calibration / sensitivities + Automation of scenario production

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Calibrating to the Japan market

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The market

Bond / Interest rate market + Longest available swap / JGB up to 40 years + Swap liquid tenors up to ~10 years Derivative implied volatilities + E.g. Nikkei 225 options up to ~10 years

What happens if we need to discount long term liabilities?

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Linkage to liability valuation

+ This generally apply to a number of areas

Yield curve Interest rate volatility Equity volatility
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Simple extrapolation: interest rate

Forwardintere estrate

USD government forward rates assuming constant rate beyond 30 years for1985-2007 Very conservative and will generate very high volatility in the MTM value of ultra long-term cash flows flows.

12% 11% 10% 9% 8% 7% 6% 5% 4% 3% 2% 0 10 20 30 40

Maturity(years)

50

60

70

80

90

100

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Macroeconomic extrapolation
Three questions: 1) What is the longest market interest rate that we can observe? 2) What is an appropriate assumption for the very long-term unconditional or f forward d rate? t ? 3) What path should be set between the longest market rate and the unconditional forward rate?

Limiting, unconditionalforwardrate/IVassumption

InterestRa ate/OptionVo olatility

Market forwards

10

20

30

40

50 60 70 Term(years)

80

90 100 110 120

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Extrapolation of interest rate

A common approach + Fitting to available market data + Setting a target for the ultra long-term forward rate + Developing an economically sensible functional form
12% 11% 10%
11% 10% 9%

Forw wardinterest rate

9% 8% 7% 6% 5% 4% 3% 2% 0 10 20 30 40

Forw wardinterestrate

8% 7% 6% 5% 4% 3% 2% 1%

Maturity(years)

50

60

70

80

90

100

10

20

30

40

50

60

70

80

90

100

Maturity(years)

+ Unconditional anchor: stability in mark-to-model valuations

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Extrapolation of derivative implied vol

+ A perfect fit to market data? + How should we extrapolate? + Economically robust, stable extrapolation l i l lead d to stable, bl sensible valuation

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Example: equity implied vol

+ One possible extrapolation approach:
Real-world volatility estimate as the limit of extrapolation... ... Adjusted for empirical option implied volatility / real-world volatility bias How fast do we revert to this long-term position?
N225Implied p VolatilitiesandExtrapolation p
45% 40%

EquityImpliedVo olatilities

35% 30% 25% 20% 15% 10% 5% 0% 0 5 10 15 20 25 30 35 40 45 50 Q42007 Q42008 Q42009 Q42010 Q Q42011

Term(years)

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Risk factor modeling

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What makes VA modeling difficult?

Embedded derivative nature + Path-dependent payoff + Multiple assets, multiple time periods Uncertainty + Insurance risks + Management actions + Policyholder options
But B are policyholders li h ld price-sensitive i ii ( (or f fully ll rational)? i l)?

Complex exposure to various financial risk factors Requires consistent multi multi-period, period multi-asset, multi asset multi-currency multi currency financial risk models for a realistic estimation of risk exposure and valuation
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Sample ESG model structure

Equity returns Property returns Alternative asset returns (e.g. commodities) Corporate bond returns

Credit risk model Real-economy; GDP and real wages

Initial swap and government nominal bonds

Nominal short rate

Inflation expectations Index linked government bonds

Exchange rate (PPP or IRP)

Real short rate Realised Inflation and alternative inflation Foreign nominal short rate and inflation

+ Joint J i t di distribution t ib ti
Correlation relationships between the shocks to different models Economically rational structure
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Real-world vs Market-consistent
A clarification of terminology Real world Real-world
Question to answer: What is the probability distribution of future asset prices? Financial projections for ALM, cashflow testing, probability of ruin analysis Calibrated to best-estimate t targets t Y

Market consistent Market-consistent

What is the current market-consistent value of future cashflows? Fair valuation of liabilities (and Greeks) Calibrated to market option-implied ti i li d volatilities l tiliti N

Usage:

Calibration: Risk premium:

The h section b below l f focuses on market-consistent k modeling d l

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I t Interest t rate t models d l

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Key consideration
+ Provide good fit to market option-implied volatility surface + Take yield curve as input + Flexibility in volatility factor specification and modeling

From a modeling perspective it generally means + A number of popular yield curve choices for MC modelling
Hull-White Cox-Ingersoll-Ross C I ll R Heath-Jarrow-Morton
+ In particular LIBOR Market Model is a market standard for rate derivatives trading

+ Fast robust calibration tools should be available for frequent q recalibrations

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Low interest environment

+ Negative interest rate issues with
Gaussian models like HW Lognormal models with displacement

+ Theoretically acceptable, but in practice

Can your ALM system handle it?

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Model choice matters

Hull-White / Vasicek Fit to initial yield curve Fit to swaption prices Calibration efficiency Distribution Negative interest rate Normal Yes Lognormal No Lognormal No Varies Yes Depends on implementation BlackKarasinski Depends on implementation LMM DDLMM + SV

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E it models Equity d l

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Black-Scholes model as a starting point

+ Model assumption affects fair valuation / pricing of liability + Among other assumption:
Returns are normally distributed Volatility is constant

Normality assumption
1.0% 0.9% 0.8% 0.7% Historic (20th Century) Stochastic Vol Model Normal Distribution

Constant volatility y assumption p

40.00% 35.00% %

Frequency y

0.6%
30.00%

0.5%
25.00%

0.4% 0.3% 0.2% 0.1% -30% -25% -20% -15% -10%

Strike
2 3 4 7 10 5 0.75 0.25 0.5

20.00% 15.00% 10.00% 5.00% 0.00%

0.0%

Equity returns in excess of risk-free rates

Maturity

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Key consideration
+ Provide good fit to market option-implied volatility surface + Support fast and frequent re-calibration + Provide simultaneous fit to multiple equity indices vol surfaces

From a modeling perspective it generally means + Going beyond Black-Scholes (constant volatility), e.g.
Stochastic volatility Correlation C l ti between b t return t and d volatility l tilit Mean reverting volatility and volatility clustering

+ But still provide (semi-) analytical calculation

Robust calibration algorithms Technology infrastructure for daily recalibration
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Market-consistent valuation
+ Model should first fit to market prices of derivatives
Market Volality Surface
Model Volality Surface

35.00%-40.00% 30.00%-35.00%

35.00%-40.00% 30.00%-35.00% 25.00%-30.00% 20.00%-25.00% 15.00%-20.00% 10.00%-15.00% 5.00%-10.00% 0.00%-5.00%

40.00%
25.00%-30.00%

40.00% 35.00% 30.00% 25.00% 20.00%

35.00% 30 00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00%

5
20.00%-25.00% 15.00%-20.00% 10.00%-15.00%

15.00%
5.00%-10.00%

10.00%
0.00%-5.00%

5.00% 0 00% 0.00%

0.00%
7 10 5

Strike
1 2 3 4 0.25 0.5 0.75

Strike
3 4 2

Maturity

0.75

+ A simple i l Bl Black-Scholes k S h l model d l cannot t fit a volatility l tilit surface f - but b t market implies one
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0.25

0.5

Maturity

7 10

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What is SVJD?
+ The SVJD model is a combination of two well known models of quantitative finance The Heston Stochastic Volatility Model Mertons Jump Diffusion Model + Benefits:
Fairly realistic but parsimonious model Generally provides a good fit to volatility surface at both long and short maturities Semi-analytic (i.e. fast) valuation formulae for vanilla option prices

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Technical specification
+ Two parts:
Stochastic volatility part, Heston model (red) Jump diffusion part, Merton model (blue)

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Example simulation
Example Simulation
Index No Jumps

Simulation of the SVJD Model 10 Year Total Return Index

Index Jumps Only Index Stochastic Volatility

200.00 180 00 180.00 160.00 140.00

45%

40%

35%

30% 120.00 25% 100.00 20% 80.00 15% 60.00 40.00 20.00 0.00 1 6 11 16 21 26 31 36 41 46 51 56 61 Month 66 71 76 81 86 91 96 101 106 111 116 10%

5%

0%

30

Stochastic Volati ility

Total Return Ind dex

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Calibrating to implied vol surface

Market Feature Implied volatility term structure Model Component Stochastic variance Key Parameters Initial variance, mean reversion level, and speed of mean reversion

Long g term skew/smile

Stochastic Variance

Return-variance correlation and volatility of variance Jump parameters

Short term skew/smile

Jump Diffusion

+ Realistic description of underlying dynamics is key + Simultaneous optimization across all parameters to market implied volatility surface
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C dit models Credit d l

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Impact of credit models

+ The impact of credit risky bonds can be highly significant
On both guarantee costs / pricing And required hedge portfolio
3.00% 2.80% 2.60%

Cost of G G'tees(% Initial Fund) )

+ Consider example of a return of premium GMAB & GMDB for a 45 year-old male for 20 years 50% invested in equities and 50% in a 10 10-yr b df bond fund... d

2.40% 2.20% 2.00% 1 80% 1.80% 1.60% 1.40% 1 20% 1.20% 1.00% Govt AA AssumedBond Strategy BBB

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Credit Modelling: Key Features

A good credit risk model should be + Arbitrage-free g migrations g and defaults + Stochastic credit rating + Stochastic variations in credit spreads + Integrated with other market risks (e.g. equities and interest rates) Model M d ld dynamic i differs diff for f diff different t applications: li ti + Real world modelling
Pricing matrix more severe than underlying transition matrix => > credit risk premium in excess of allowance for expected defaults

+ Risk neutral modelling

Pricing matrix as severe as underlying transition matrix => risk neutral

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Requirement for hedging and hedge projection

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Projection of hedging strategies

+ Real-world model capturing hedging strategys key risk exposures
Vega: Increases in option-implied volatility levels Gamma: Real Real-world world volatility levels exceeding option option-implied implied vol assumption

+ Integrated modelling of equity total returns and changes in the level of equity option-implied volatilities
50% 45%
1.0

UK Volatility (LHS) US Volatility (LHS) UK vs US Correlation (RHS)

40% 35% 30% 25% 20% 15% 10% 5% 0%

De c63 De c68

0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0

De c73

De c78

De c83

De c88

De c93

De c98

De c03

5Y Rolling g Correlation

0.9

5Y Rollin ng Volatility

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Long-term Hedging P/L Analysis

+ Long-term profitability of delta hedging strategy driven by how realized volatility behaves relative to implied volatility levels
Expected real-world volatility vs option-implied volatility Variability of real-world volatility
1.50% 1.25% 1.00% 0.75% 0.50% 0.25% 0.00% 0.25% -0.25% -0.50% -0.75% -1.00% -1.25% -1.50% -1.75% -2.00% 2 00% 15.0% 12.5% 10.0% 7.5% 5.0% 2.5% 0.0% -2.5% 2.5% -5.0% -7.5% -10.0% -12.5% -15.0% -17.5% -20.0% 20 0%

S&P500PriceChange CumulativeDeltaHedgingP/L

1 3 5 7 9 1113151719212325272931333537 TradingDay(October1st November20th'08)

DailyS&P500PriceChane(%)

CumulativeH HedgingLosses (%ofunder rlyinhgfund)

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Variance reduction for risk assessment

+ Hedge projection requires Greeks projection
Estimation of Greeks at each point in each real-world simulation requires stochastic-on-stochastic (theoretically)

+ Variance reduction for Greeks calculation

E.g. Least Squares Monte Carlo to efficiently capture future liability valuation dynamics

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Example LSMC for projected Greeks

+ Simple Black-Scholes example
projection of 10-year vanilla put option

+ 10,000 outer scenarios and 2 inners per outer

Higher numbers of inner sims can be used to increase accuracy

+ Fit cubic function and differentiate to estimate delta

Value (after 1 year)
0.5
True value (Black-Scholes)

Delta (after 1 year)

0 -0.1 0.5 1 1.5 2 2.5

Put Option Value @ Year 1

I iti l (2 Initial (2-scenario) i ) estimate ti t Regression estimate

Put O Option Delta @ Year 1

0.4

-0.2 0.2 -0.3 -0.4 -0.5 -0.6 -0.7 -0.8 -0.9 -1

True delta (Black-Scholes) Regression estimate

0.3

Differentiate fitted polynomial

0.2

y = -0.1367x3 + 0.74x2 - 1.4881x + 1.1539

0.1

0 0.5 1 1.5 2 2.5

Equity Price @ Year 1

Equity Price @ Year 1

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Concluding remarks
+ Market risk modeling impacts
Fair and adequate pricing / valuation / capital Design / risk exposure of hedging strategy

+ Model choice and calibration, among others, have significant impact on valuation and requires judgment

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Thank You!

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