Applications of Arbitrage-free Models:

New Frontiers in Interest Rate, Credit and

Energy Risks
Third Annual Bloomberg Lecture in Finance
THOMAS S. Y. HO PhD
PRESIDENT
THC
OCTOBER 26, 2009
TOM.HO@THOMASHO.COM

Arbitrage-free Term Structure Models

2

Valuation models

Derivative pricing (relative valuation) under interest rate, credit and

other risk drivers

Applications

Trading
Portfolio management
Enterprise risk management

Impacts on the markets

Price discovery process

Regulatory policies in the financial markets

Introduction

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Questions Addressed
3

What are the models economic principles that make

the model popular and fundamental?

What are the frontiers of applications of the model in
going forward?
What are my cautionary notes on the use of the model?
Detail discussions are available in the references

Introduction

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References
4
Amin,

Kaushik I., and Andrew J. Morton, 1994, Implied Volatility Functions in Arbitrage-free Term Structure Models, Journal of Financial Economics, 35
(2), 141-180
Benth, Fred Espen, Lars Ekeland, Ragner Hauger and Bjorn Fredrik Nielsen 2003 A Note on Arbitrage-free Pricing of Forward Contracts in Energy Market
Applied Mathematical Finance 10, 325-336
Eydeland, Alexander and Krzysztof Wolyniec 2003 Energy and Power Risk Management, Wiley Finance
Harrison, J Michael, and David M. Kreps, 1979 Martingales and Arbitrage in Multiperiod Securities Markets< Journey of Economic Theory, 20(3), 381-408
Ho, Thomas S. Y. 1992 Key rate durations: measures of interest rate risks Journal of Fixed-Income, 2(2), 19-44
Ho, Thomas S. Y. and Sang-Bin Lee 2003, The Oxford Guide to Financial Modeling, Oxford University Press
Ho, Thomas S. Y. and Sang-Bin Lee 1986, Term Structure Movements and the Pricing of Interest Rate Contingent Claims, Journal of Finance, 41 (5), 10111029
Ho, Thomas S. Y. and Sang Bin Lee,2009 Valuation of Credit Contingent Claims: An Arbitrage-free Credit Model Journal of Investment Management vol 7
No 5
Ho, Thomas S. Y. Ho and Sang Bin Lee, 2009 A Unified Credit and Interest Rate Arbitrage-Free Contingent Claim Model Journal of Fixed-Income
Ho, Thomas S. Y. and Blessing Mudavanhu,2007 Stochastic Movement of the Implied Volatility Function Journal of Investment Management 4 th quarter
Ho, Thomas S. Y. and Sang Bin Lee, 2007 Generalized Ho-Lee Model: A Multi-factor State-Time Dependent Implied Volatility Function Approach Journal
of Fixed Income 4th quarter
Ho, Thomas S. Y. 2007 Managing Interest Rate Volatility Risk: Key Rate Vega Journal of Fixed Income 4 th quarter
Ho, Thomas S. Y. and Sang-Bin Lee 2009 A Unified Model: Arbitrage-free Term Structure Movements of Flow Risks
Ho, Thomas S. Y. and Sang Bin Lee Pricing of Contingent Claims on Natural Gas working paper
Nawalkha, Sanjay K., Natalia A. Beliaeva and Gloria M Soto 2007 Dynamic Term Structure Modeling Wiley Finance

References

2/14/16

Outline
5

Salient features of the model

A perspective of arbitrage-free term structure models

A framework to explore new frontiers in applications

Apply the framework to

Interest rate risk

Credit risk
Energy risk

Going forward: Managing model risks

Edwards Deming approach to risk management

Introduction

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The Black-Scholes Model

Components of an Arbitrage-free Model
6

Valuation component

C(

S, t) Specify the contingent claim

dS = r(t) Sdt + (t) Sdz

Specify the underlying risk process

Application component
Delta:

dynamic replication
Calibration to determine the implied volatility
Arbitrage-free Models

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Arbitrage-free Term Structure Model

Valuation Component of the Model
7

C = C( r , p(t, T), t)

Contingent claims on the discount function

dr = F( p(t, T), t)dt + (r, t) dw

Short rate model

Forward rate model
Market model

X(n-1,i) = 0.5 p(n,i)(B(n,i) + B(n, i+1))

Rolling back adjusted by the discount rate

B(n-1, i) = max ( X(n-1, i), K)

Arbitrage-free models

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Key Rate Duration Dynamic Replication Application Component of

the Model
8

Callable bond
Maturity 2020-10-15
SA fixed coupon rate

5.65%
Bermudan callable at par
Used for hedging, risk
management, and
investment
Arbitrage-free Models

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Implied Volatility Function

Calibration: Application Component of the Model
9

Arbitrage-free Models

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Term Structure Models and the Black-Scholes

Model: a Comparison
10

The term structure model: Time dimension, rate, a

flow concept
From

the economic modeling perspective, the Black

Scholes model is not a special case of a term structure
model hence term structure

Correlations of the securities of the term structure:

Principal component methods

Ho, Thomas S. Y. and Sang-Bin Lee 2009 A Unified Model: Arbitrage-free Term Structure Movements of
Flow Risks
Arbitrage-free models
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Proposed Perspective of Term Structure Models

Stock versus Flow

11

Arbitrage-free

models have two components

Valuation component (some examples)
Multi-factor models
Time and state dependent implied volatility function
Unspanned stochastic volatility function
Application component
Effectiveness of dynamic hedging and implications of the
implied volatilities
Arbitrage-free Models

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Credit Term Structure

12

Valuation of fixed-income instruments with credit risk

Reduced

form and structural models

Credit default swap (CDS)
Survival function vs discount function
State and time dependent survival rate s(n,i)
Ho, Thomas S. Y. and Sang Bin Lee,2009 Valuation of Credit Contingent Claims: An
Arbitrage-free Credit Model Journal of Investment Management vol 7 No 5

Applications: Credit Risk Modeling

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Valuing Credit Contingent Claims

Valuation Component of the Model
13

Make-whole Option
X(n-1,i) = 0.5 p(n) s(n,i) (B(n,i) + B(n, i+1))
Rolling

back adjusted by the survival rate

B(n-1, i) = max ( X(n-1, i), K)
Boundary and terminal conditions
p(n) one period time value discount factor
K strike price (an example), present value of the yield adjusted
Treasury bonds
Applications: Credit Risk Modeling

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Valuation of Embedded Credit Options

14

Applications: Credit Rsk Modeling

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Implications of the Credit Term Structure

Application Component of the Model
15

Determine the credit key rate durations for credit

hedging
Specify

the precise dollar credit exposure in the term

structure

Identify the implied credit volatilities

Use

of the structural models

Interest rate and credit risk relationship

Applications

to a callable instruments

Applications: Credit Risk Modeling

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Applications of the Term Structure Credit Model

16

Dynamic movements of the term structure of credit

Specify the embedded make whole option in

commercial mortgages

Impact of the correlation to the interest rate level

Relating a reduced form model to the structural model

Multi-factor credit model

Applications: Credit Risk Modeling

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Natural Gas Futures Term Structure

17

Basic economics of natural gas: Henry Hub data

Well head cost, gathering and processing costs
Storage and cost to carry
Demand: Weather affects heating; power generation
Injection

season: April - October

Withdrawal season: November March
Ho, Thomas S. Y. and Sang Bin Lee Pricing of Contingent Claims on Natural Gas
working paper
Applications: Energy Risk Modeling

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Importance of Modeling NG Term Structure

18

Deregulation of power industry

Supply: Horizontal rigs
Power prices
Depending

on the bid stack and power demand

Bid stack depends on the fuel price and the outage
Use of derivatives to manage energy risk and capital
investments
Applications: Energy Risk Modeling

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Modeling of the Natural Gas Price Process

19

Abadic, Luis M and Jose Chamorra (2006)

2 factor model with the stochastic fuel price mean reverting to a

stochastic long term price
The stochastic long term price mean reverting to a constant price

Eydeland, Alexander and Krzysztof Wolyniec (2003)

and Benth et al (2003)

Use arbitrage-free models

Ho and Lee (2009)

Identify the term structure flow risk and the stock risk

Applications: Energy Risk Modeling

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Data and Methodology

20

Futures and spot daily prices from 1/3/2006

-12/27/2006
Futures delivery dates: monthly from 1/1/2007 and
1/1/2010
Implied cost of carry c(t, T) = (1/(T-t))ln F(t,T)/S(t)
Use the principal component approach to specify the
movements
Data Source: Logical Information Machines (LIM)
Applications: Energy Risk Modeling

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Henry Hub $ MMBtu (12/12/05-8/7/09)

21
18
16
14
12
10
8
6
4
2
0

Applications: Energy Risk Modeling

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Term Structure of Henry Hub Futures Prices

10/16/2009
22

Futures Prices

7 .5
7
6.5
6
5.5
5
4.5
4

Applications: Energy Risk Model

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Natural Gas Futures Term Structure

Movements
23
13

12

11

10

Applications: Energy Risk Modeling

1/3/2006
1/4/2006
1/5/2006
1/6/2006
1/9/2006
1/10/2006
1/11/2006
1/12/2006
1/13/2006
1/17 /2006
1/18/2006
1/19/2006
1/20/2006
1/23/2006
1/24/2006
1/25/2006
1/26/2006
1/27 /2006
1/30/2006
1/31/2006

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Arbitrage-free Natural Gas Model

Valuation Component of the Model
24

Contingent claims on the NG spot and futures prices

Implied cost to carry: The term structure
Futures contracts determining the implied cost of carry
The one period cost to carry is equivalent to the survival rate
Dynamics of the term structure: The term structure of

cost to carry and the spot rates

dS = c(t) S dt + (t) S dz
dc(t) = F( c(t, T), t) dt + * dw

Applications: Energy Risk Modeling

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Preliminary Results on Dynamic Hedging

Application Component of the Model
25

The futures term structure movements have two

factors: Price (85%), Cost to Carry (14%), 3rd vector

(0.3%)
The cost of carry movements has one factor: level
movement (99.5%) and 2nd factor (0.4%)
Correlation of the spot price and cost to carry: low
The use of key rate durations on the cost to carry and
the spot price for hedging
Applications: Energy Risk Modeling

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1st Principal Movement of the Cost to Carry

26

Price
-0.16
-0.16
-0.16
-0.16
-0.16

Rate Shift

-0.16
-0.16
-0.16
-0.17
-0.17

Maturity
Applications: Energy Risk Modeling

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2nd Principal Movement of the Cost to Carry

27

Slope
0.3
0.2
0.1
0
Rate Shift

-0.1
-0.2
-0.3

Maturity

Applications: Energy Risk Modeling

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Calibrate the Model to the Implied Volatilities

Application component of the Model

28
60
2006-01-03
2006-01-04
2006-01-05
2006-01-06
2006-01-09
2006-01-10
2006-01-11
2006-01-12
2006-01-13
2006-01-17
2006-01-18
2006-01-19
2006-01-20
2006-01-23
2006-01-24
2006-01-25

50

40

30

20

10

0
1

Applications: Energy Risk Modeling

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

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Implications to Energy Trading

29

Quantitative analysis of NG contracts and the changing

shape of the implied cost to carry curve

Relate the NG futures option prices and to other
derivatives
Applications to the calendar basis trades

Use of the multi-factor model to determine the correlations of the cycles

Correlation of interest rates with the cost to carry curve

Power stack function: relation to coal and crude oil
Applications: Natural Gas Contracts

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Going Forward
30

A lesson learnt from the financial crisis

Mispricing and hence misallocation of resources
Justification for the dynamic replication and volatility

calibration

Revisiting the application component of an arbitrage-free model

Internal consistency of the model

Manage Model Risks

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Managing Model Risk

31

Example of mis-valuation: The CDO copula model

The use of implied correlations

How to manage model risk?

Managing Model Risks

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A Solution to Managing Model Risk (Deming)

32

Deming: Statistical approach to quality control

Defects are often traced directly to the cause. But

Statistical approach is more objective
Catching the defects when they are small

Return attributions of Treasury futures

Cheapest to deliver
Delivery options, timing options, end of month options

Managing Model Risks

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Return Attribution and Risk Management

33

Data source: BGCantor Market Data

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Analysis of the Model Risk

34

Explanatory power of the model?

Mean reversion behavior of the residuals?
Effectiveness of the dynamic replication?
Detect defects in the time series in relation to events

Manage Model Risks

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Analysis of the Residuals over the Roll Month

35

September and December 5 year futures over the

month of September
Market price = Mid quotes
10 minute intervals from 7:00am till 5:30 pm
Both the explanatory power and mean reversion rate
decline by mid month
This behavior varies across the contracts
Manage Model Risks

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Explanatory Power Metric : R squared

p(market)= a + b p(model) + e
36
5y r-Sep09

5y r-Dec09

120.00%
100.00%
80.00%
60.00%
40.00%
20.00%
0.00%

Data source: BGCantor Market Data

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Explanatory Power Metric : R squared

p(market)= a + b p(model) + e
37
10y r-Sep09

10y r-Dec09

120.00%
100.00%
80.00%
60.00%
40.00%
20.00%
0.00%

Data source: BGCantor Market Data

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Mean Reversion Metric: ( 1 -b )

ch/rh(n) = a + b ch/rh(n-1) + e
38
5y r-Sep09

5y r-Dec09

120.00%
100.00%
80.00%
60.00%
40.00%
20.00%
0.00%

Data source: BGCantor Market Data

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Mean Reversion Metric: ( 1 -b )

ch/rh(n) = a + b ch/rh(n-1) + e
39
10y r-Sep09

10y r-Dec09

120.00%
100.00%
80.00%
60.00%
40.00%
20.00%
0.00%

Data source: BGCantor Market Data

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Replication Metric : R squared

p(model) = a + b TSY returns + e
40
Date

5yr-Dec09

10yr-Dec09

10yr-Mar10

30yr-Dec09

30yr-Mar10

10/7/2009

0.9099

0.9908

0.9612

0.9724

0.7282

10/9/2009

0.8300

0.9894

0.9767

0.9580

0.9755

10/13/2009

0.9009

0.9926

0.9812

0.9864

0.9893

10/14/2009

0.7084

0.8854

0.7809

0.7777

0.8822

10/15/2009

0.8597

0.9647

0.9376

0.8452

0.9215

10/16/2009

0.8288

0.9931

0.9700

0.7679

0.8971

Data source: BGCantor Market Data

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Summary: Proposed Perspective

41

Term structure models deal with rates, flows ( interest rate, default rate,

cost to carry, inflation rate )

Contrast to the Black-Scholes
Valuation and application components to the model
Similar to the Black-Scholes
Manage model risk: Statistical approach (Deming)
Examples of term structure
Interest rate, credit, energy
Natural gas shows the use of both price and rate models
Conclusions

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Conclusions and Implications

42

Trading

Return attributions on performance measure

Model risk

Statistical Approach: explanatory, mean reversion, replication

Securities valuation

Interest rate, default rate, inflation rate, liquidity, cost to carry

Hybrid models

Identifies the price formation process

From the basic valuation building blocks to exotic structures

Regulatory policy on market transparency and the role of exchanges

Conclusions

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References
43
Amin,

Kaushik I., and Andrew J. Morton, 1994, Implied Volatility Functions in Arbitrage-free Term Structure Models, Journal of Financial Economics, 35
(2), 141-180
Benth, Fred Espen, Lars Ekeland, Ragner Hauger and Bjorn Fredrik Nielsen 2003 A Note on Arbitrage-free Pricing of Forward Contracts in Energy Market
Applied Mathematical Finance 10, 325-336
Eydeland, Alexander and Krzysztof Wolyniec 2003 Energy and Power Risk Management, Wiley Finance
Harrison, J Michael, and David M. Kreps, 1979 Martingales and Arbitrage in Multiperiod Securities Markets< Journey of Economic Theory, 20(3), 381-408
Ho, Thomas S. Y. 1992 Key rate durations: measures of interest rate risks Journal of Fixed-Income, 2(2), 19-44
Ho, Thomas S. Y. and Sang-Bin Lee 2003, The Oxford Guide to Financial Modeling, Oxford University Press
Ho, Thomas S. Y. and Sang-Bin Lee 1986, Term Structure Movements and the Pricing of Interest Rate Contingent Claims, Journal of Finance, 41 (5), 10111029
Ho, Thomas S. Y. and Sang Bin Lee,2009 Valuation of Credit Contingent Claims: An Arbitrage-free Credit Model Journal of Investment Management vol 7
No 5
Ho, Thomas S. Y. Ho and Sang Bin Lee, 2009 A Unified Credit and Interest Rate Arbitrage-Free Contingent Claim Model Journal of Fixed-Income
Ho, Thomas S. Y. and Blessing Mudavanhu,2007 Stochastic Movement of the Implied Volatility Function Journal of Investment Management 4 th quarter
Ho, Thomas S. Y. and Sang Bin Lee, 2007 Generalized Ho-Lee Model: A Multi-factor State-Time Dependent Implied Volatility Function Approach Journal
of Fixed Income 4th quarter
Ho, Thomas S. Y. 2007 Managing Interest Rate Volatility Risk: Key Rate Vega Journal of Fixed Income 4 th quarter
Ho, Thomas S. Y. and Sang-Bin Lee 2009 A Unified Model: Arbitrage-free Term Structure Movements of Flow Risks
Ho, Thomas S. Y. and Sang Bin Lee Pricing of Contingent Claims on Natural Gas working paper
Nawalkha, Sanjay K., Natalia A. Beliaeva and Gloria M Soto 2007 Dynamic Term Structure Modeling Wiley Finance

References

2/14/16