mark to future

A framework for measuring risk and reward

Ron S. Dembo, Andrew R. Aziz, Dan Rosen and Michael Zerbs

May 2000

Algorithmics Publications
Mark-to-Future
Technical Document
Editor
Judith M. Farvolden
Editorial Assistance
Lynn Coulthard, Christine Farmery,
Marguerite Martindale
Editorial Board
Andrew Aziz
Judith M. Farvolden
Dan Rosen
Stephen A. Ross
Michael Zerbs
Layout
Tammy McCausland
http://www.mark-to-future.com
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Editorial
I suspect that the first trade-off between return and risk occurred when a
caveman had to decide whether to spear a mastodon or run. The relevant
scenarios probably sped instinctively through the neurons. Stand and
throw the spear. If successful, have a fine feast, if not, get trampled. Or,
run and go hungry but live to hunt another day.
We naturally deal with risky situations by contemplating the outcomes
and musing about possible scenarios. Oddly, though, as we have grown
more sophisticated in the world of financial risk control, we have often
left this intuitive and common sense approach behind us in favour of
technically more formal approaches such as “mean-variance.” There is
nothing inherently wrong with these formal ways of analyzing risky
situations, but it is wrong to think that they have the same universal
applicability as the scenario approach. They are, after all, just special
cases of the caveman’s scenario analysis.
Mark-to-Future is a full-scale realization of the scenario approach. It
addresses risk and return by examining possible futures, i.e., scenarios,
and by cataloguing their effects on financial positions and portfolios. It is
based on the most fundamental of economic models: the state space
approach to uncertainty. In this view of the world, a state of nature is a
realization of uncertainty, i.e., a possible scenario. In each state of nature,
assets and portfolios are marked-to-market along the future scenario,
whence Mark-to-Future. Risk and reward analysis consists of tabulating
all of the financial consequences of each state of nature and then making
decisions by trading off the benefits in some scenarios against the losses in
others.
While this is easy to grasp conceptually, it is a Herculean task to make it
practical. First and foremost, we have to identify the economic drivers of
future valuations. Then we have to generate a meaningful set of scenarios
that spans the relevant future possibilities for those drivers. Along each
scenario, assets must be priced and they must be priced with a full
understanding of all of their cash flows, of liquidity and trading issues and
of the policy decisions that will be made as the scenario unfolds.
Fortunately, there is a major simplification—the Mark-to-Future Cube—
that allows these computational tasks to be undertaken in an efficient
and easily decentralized fashion.
This book, the result of 10 years of effort by the men and women of
Algorithmics, describes the practical achievements that have taken their
vision, spearheaded by Ron Dembo, and turned it into a working reality
that is being implemented in the market place today. This work is what
risk monitoring and measurement in financial markets should be about
and now, thanks to them, it is what risk management can actually be.
The next ten years will see this approach become the standard for
financial risk monitoring, analysis and regulation.
Stephen A. Ross
Guest Editor
With Thanks
The editors would like to acknowledge the individuals listed here for
their contributions. Our sincere thanks for their diligent efforts
which made the Mark-to-Future Technical Document possible.

Internal Referees

Nisso Bucay
Olivier Croissant
Ben De Prisco
Neil Dodgson
Joan den Haan
Alexander Kreinin
Asif Lakhany
Helmut Mausser
Jivantha Mendes
Leonid Merkoulovitch
Savita Verma
Hao Wang

Contributors

Ben De Prisco
Nisso Bucay
Olivier Croissant
Doug Gardner
Alexander Kreinin
Helmut Mausser
Savita Verma
Hao Wang
Preface
Ten years ago, Algorithmics was formed in response to the complex
issues surrounding risk management in banking. At that time, even the
most advanced financial institutions associated risk management with
instantaneous hedging of an options book. We recognized then that to
proactively measure and manage risk and reward, one needed to know
the total exposure of the institution across all of its global activities.
This gave birth to what is today referred to as enterprise risk
management or ERM. Since then, our software has helped to transform
the way in which approximately 100 banks, asset managers, insurance
companies and corporations, in 20 countries, are able to measure their
risk and manage their capital. At the heart of our software solution is
the Mark-to-Future methodology.
We have decided to make Mark-to-Future generally available as a
proposed new standard for risk/reward measurement. This innovative
approach to risk measurement significantly extends current
methodologies. It conforms not only with existing regulatory
requirements, but also to proposed regulatory changes. It responds
perfectly to the calls by regulators for a comprehensive framework and
not “formulaic approaches to risk” (Greenspan 1999). As the first truly
forward-looking risk/reward framework, we believe Mark-to-Future has
the potential to change the industry by profoundly affecting the way
risk management and capital allocation are practised in financial
institutions. Most importantly, since Mark-to-Future is a generic
framework and not based on a single formula or method, we believe it
will evolve with risk management practice.
Mark-to-Future allows for portfolios that may change over time and
under differing scenarios. By taking into account the effects of
changing portfolios at future points in time, a more realistic assessment
of risk is possible. Mark-to-Future provides a natural basis for linking
market, credit and liquidity risk. It also provides a unified framework
(the Put/Call Efficient Frontier) for calculating the risk/reward trade-
off of any combinations of these risks.
In a Mark-to-Future world, the fundamental input is scenarios and the
emphasis is on instruments, not portfolios. Since the framework is
additive, the Mark-to-Future of a portfolio is simply the same
combination of each instrument's Mark-to-Future, regardless of the
nature of the security. Accordingly, once a decision has been made
with respect to the future scenarios and the instruments one is likely to
trade, the Mark-to-Future values of these instruments may be
computed well before the actual portfolio composition has been
determined. This makes computation of marginal near-time risk/
reward measurement feasible, even for large institutions. With current
simulation methods this is impossible, since prior to a risk calculation
one needs to assemble all portfolios centrally, which is extremely time
consuming and fraught with difficulty.
What is Mark-to-Future?
A new, adaptable, multi-step,
dynamic simulation framework
that integrates disparate sources
and measures of risk and
reward. Algorithmics has
proposed Mark-to-Future, or
MtF, as a standard for evolving
financial risk/reward
measurement.
What outstanding problems
does MtF address?
• Measures the risk/reward of
portfolios that are dynamic
in nature.
• Captures the impact of
settlement, maturity and
trading/investment
strategies.
• Provides a framework for
computing liquidity risk.
• Captures the interaction of
market, credit and liquidity
risk and reward.
• Makes simulation-based
pre-deal risk analysis a
reality for large institutions.
• Computes marginal market
and counterparty credit risk
in near time.
• Measures accurately risk/
reward for all types of
financial instruments.
• Addresses the needs of
large and small institutions
in a consistent manner.
• Breaks the major barrier to
risk services—it is not
necessary to disclose
holdings to outsource risk
calculations.
What are the business benefits
of MtF?
• Consolidates market risk,
credit risk, liquidity risk and
ALM functions in one
consistent framework for
efficient capital allocation
and risk management.
• Enables truly distributed
risk management.
• Provides a common
language for technical and
non-technical risk
managers.
• Adapts to changes as risk
management needs evolve.
Most importantly, we believe that Mark-to-Future will break down
significant barriers to the risk service bureau business and make risk
management outsourcing a reality, by making it possible for institutions
to obtain risk management services without divulging their portfolios.
This will level the playing field and put smaller institutions on an equal
footing with even the biggest of banks. The same risk management
analytics, formerly very expensive and available to only the largest
financial institutions, will be easily accessible. Ultimately, this will lead
to far more extensive and better risk management worldwide.
Mark-to-Future will also revolutionize application development and
risk architecture. The additive nature of Mark-to-Future makes truly
decentralized risk architecture possible. Mark-to-Future eliminates the
need for monolithic applications; instead, software can be created to
meet the specific needs of each and every business unit within financial
institutions. These “thin client” applications will be network-enabled
and will access pre-computed Mark-to-Future data. Because
applications can be built quickly and easily and do not require a large
investment, they may be modified quickly to adapt to an ever-changing
risk management landscape.
This document and the implementation of the ideas herein is the result
of a collaborative undertaking, over a 10-year period, by an extremely
knowledgeable, dedicated and talented workforce at Algorithmics. In
particular, I would like to thank Bob Boettcher, Alex Kreinin, Savita
Verma, Olivier Croissant, Ben De Prisco, Judy Farvolden, Helmut
Mausser, Doug Gardner, Michael Durland and David Penny for their
contributions to material in this book and to the methodology itself.
An earlier version of this document appeared in Dembo et al. (1999)
and in summarized form in Dembo (1998a, 1998b). We have also
presented the ideas herein at industrial conferences over the years.
Many of our colleagues, both clients and non-clients, have provided
invaluable comments on this proposed standard. In particular, I would
like to acknowledge the feedback from Carol Alexander, Jean-Louis
Bravard, Michael Durland, Robert Fiedler, Andrew Freeman, Arthur
Geoffrion, Fabiano Gobbo, André Horovitz, Chuck Lucas, Robert
Mark, Gary Nan Tie, Ariel Salama, Charles Smithson, Lawrence Tabb,
Debbie Williams and Rudi Zagst.
I would also like to extend my gratitude to Stephen Ross for his advice,
insight and detailed comments, which have resulted in significant
improvements to this manuscript. Stephen worked tirelessly with the
Algorithmics’ research team to refine the presentation and ensure that
the material was consistent, accurate and appropriate for the target
audience.
The Mark-to-Future framework is the latest milestone in an incredible
journey to understand risk and reward. It is not abstract theory. The
ideas presented here have been tried and tested and are available in
our products today. We anticipate that this framework will evolve and
grow over time and consequently welcome and look forward to your
feedback. Updates to the methodology as well as discussions, critiques
and commentary will be posted on www.mark-to-future.com.
Ron S. Dembo,
Toronto, April 2000
Table of Contents

A Call for a Framework ....................................................................... 1

We introduce the Mark-to-Future methodology and describe how this unifying framework
advances the standard of risk management practice and oversight.

Step 1: Defining Scenarios and Time Steps ..........................................7

The explicit choice of scenarios is the key input to a Mark-to-Future analysis. They directly
determine the future distributions of portfolio MtF values, the dynamics of portfolio
strategies, the liquidity in the market and the creditworthiness of counterparties and
issuers.

Step 2: Defining the Basis Instruments ............................................... 33

The choice of basis instruments to be simulated in the pre-Cube stage of the Mark-to-
Future framework depends on the overall business application and may involve trade-offs
between the magnitude of data storage and pricing accuracy.

Step 3: Simulating to Produce the MtF Cube ....................................... 39

Once the scenarios and time steps have been defined, the MtF Cube is generated by
simulating the MtF values over scenarios and time steps.

Step 4: Producing the Portfolio MtF Table ............................................ 41

Any portfolio or portfolio regime can be represented by mapping the MtF Cube into static
or dynamically changing portfolio holdings. The regimes may be predetermined or
conditional upon the scenario-based MtF values. Conditional regimes are used to capture
liquidity risk.

Step 5: Producing the Desired Risk/Reward Measures ........................... 55

The actual risk and reward measures chosen to characterize future uncertainty can be
arbitrarily defined and incorporated strictly in the post-Cube stage.

Step 6: Advanced Mark-to-Future Applications ..................................... 63

MtF Cubes may serve as input for applications more complex than calculating simple
risk/reward measures. Portfolio or instrument MtF tables may be used as input to an
integrated market and credit risk framework and scenario-based optimization tools.

References ........................................................................................ 75
Notation ...........................................................................................79
ARQ Review ...................................................................................... 81
List of Figures

Figure A.1: Representative MtF Cube ............................................................................. 4

Figure A.2: Schema of the MtF methodology ................................................................ 5
Figure 2.1: Mapping sequence of risk factor through to portfolio ................................ 34
Figure 2.2: Mapping sequence A .................................................................................. 34
Figure 2.3: Mapping sequence B .................................................................................. 35
Figure 2.4: Mapping sequence C .................................................................................. 35
Figure 2.5: MtF values of all-in t = 2 zero coupon instrument across scenarios .......... 36
Figure 2.6: MtF values of all-in t = 0 zero coupon instrument across scenarios .......... 37
Figure 2.7: MtF values of an all-in t = 4 zero coupon instrument across scenarios ..... 37
Figure 3.1: Generation of the Basis MtF Cube ............................................................. 39
Figure 4.1: Portfolio mapping sequence ....................................................................... 42
Figure 4.2: Mapping of a bond into a portfolio liquidation strategy ............................ 42
Figure 4.3: Mapping of products for an attribution analysis ........................................ 46
Figure 4.4: Mapping Treasury bills into a portfolio roll-over strategy ......................... 48
Figure 4.5: Mapping financial products into a portfolio delta-hedging strategy .......... 49
Figure 4.6: Portfolio mapping sequence with abstract basis ......................................... 49
Figure 4.7: Mapping zero coupon basis instruments into a swap ................................. 50
Figure 4.8: Mapping zero coupon basis instruments into zero bond ............................ 51
Figure 5.1: Mark-to-market of the portfolio over a range of DAX values ................... 57
Figure 5.2: Positive drift associated with the portfolio ................................................. 57
Figure 5.3: Changes in portfolio MtM values across Monte Carlo scenarios .............. 58
Figure 5.4: Portfolio MtF values over 100 scenario paths ............................................ 58
Figure 5.5: Dynamic MtF values over 100 scenario paths ........................................... 59
Figure 5.6: Transforming portfolio MtF values ............................................................ 60
Figure 6.1: Integrated market and credit risk in the MtF framework ........................... 66
Figure 6.2: Efficient frontier ......................................................................................... 72
List of Tables

Table 1.1: MtF scenarios for various applications .........................................................11

Table 2.1: MtF values of all-in stock instrument ...........................................................36
Table 2.2: MtF values of all-in t = 2 zero coupon instrument ......................................37
Table 5.1: Selected market risk measures ......................................................................56
Table 5.2: Selected liquidity risk measure .....................................................................56
Table 5.3: Selected reward measures .............................................................................57
Table 5.4: Transformation of MtF values to credit exposure measures .......................59
Table 5.5: Selected credit risk measures ........................................................................61
Table 5.6: Selected performance measures ....................................................................62
Table N.1: Indices ..........................................................................................................79
Table N.2: Variables and parameters .............................................................................79
Table N.3: Functions ......................................................................................................80
Table N.4: Notation for Step 5 .......................................................................................80
Table N.5: Coefficients ..................................................................................................80
A Call for a Framework
In a 1999 address, Alan Greenspan, Chairman of the US Federal Reserve Board
(1999), questioned the suitability of formulaic approaches for the assessment of risk
and espoused the development of a framework that is adaptable to the inevitable
changes in supervision and regulation:

We are striving for a framework whose underlying goals and broad strategies can remain
relatively fixed, but within which changes in application can be made as both bankers and
supervisors learn more, as banking practices change, and as individual banks grow and
change their operations and risk-control techniques. Operationally, this means that we
should not view innovations in supervision and regulation as one-off events. Rather, the
underlying framework needs to be flexible and to embody a workable process by which
modest improvements in supervision and regulation at the outset can be adjusted and fur-
ther enhanced over time as experience and operational feasibility dictate. In particular, we
should avoid mechanical or formulaic approaches that, whether intentionally or not, effec-
tively ‘lock’ us into particular technologies long after they become outmoded. We should be
planning for the long pull, not developing near-term quick fixes. It is the framework that
we must get right. The application might initially be bare-boned but over time become
more sophisticated.

Governor Laurence H. Meyer of the US Federal
Reserve Board (1999) echoed the views of many
regulators who vigorously advocate increasing
both the scale and the scope of public disclosure
of information for various risk categories, most
notably credit exposure and credit concentration.
Governor Meyer identified internal bank systems
as the first lines of defence in the prevention of
undue risk-taking, and was quick to point out
that supervision and regulation should not
duplicate the efforts of increasingly sophisticated,
internal best-practice risk management systems.
Notwithstanding these sentiments, coupling
minimum capital regulation to the internal risk-
profiling system of a bank is a large and daunting
task.
Our goal at Algorithmics in writing this book is
to describe a standard framework for simulation-
based risk management that links together
market, credit and liquidity risks. Mark-to-Future
is an open, flexible and extensible framework
that advances best-practice risk management as
advocated by Meyer and systematically satisfies
the requirements set out by Greenspan. It is
designed to accommodate evolving standards
and, as a framework, does not “lock” into any
particular technology so as not to become
outmoded as technology changes. As Greenspan
contends, risk management is all about the
fundamentals: “It is the framework that we must
get right.” In what follows, we introduce the
Mark-to-Future methodology and describe how
this unifying framework advances the standard of
risk management practice and oversight.
Mark-to-Future is the product of over 10 years of
research by Algorithmics’ financial and software
engineers. However, Mark-to-Future is not just a
theory—it is the basis of Algorithmics’ risk
management solution, AlgoSuite. AlgoSuite has
helped transform the way more than 100 banks,
asset managers and corporations in 18 countries
measure their risk and manage their capital.
Today, as the leading software provider with the
most experienced team in the industry,
Algorithmics continues to develop and market
enterprise risk management solutions that
2 A call for a framework
address the ever-increasing complexity of
financial markets and growing regulatory
pressures.
Risk and reward in an uncertain future
At the heart of every investment decision is the
question, “What will be the value of a given
portfolio at some future time horizon?” The
uncertainty inherent in virtually all investment
choices implies that this question can only be
effectively addressed by assessing a range of
possible future outcomes. The decision to invest
in a given security is made on the basis of some
trade-off between the security’s contribution to
overall risk and reward.
Risk and reward are typically quantified by
measures computed from the distribution of
future portfolio values. For example, risk is often
measured by a statistic or descriptor such as
variance, Value-at-Risk (VaR), worst case or
regret while reward is often measured by a
statistic such as mean return, expected profit or
expected upside.
Traditional approaches to quantifying this trade-
off are typically constrained by narrow
assumptions, implicit or explicit, regarding the
shape of the distribution and the choice of
appropriate statistics or descriptors that
characterize the distribution. In most cases, these
assumptions are inextricably bound together in
the formulation of the model because a given
statistic serves as the key information input. As
such, the choice of a particular risk/reward
measure invariably precludes arbitrary choices of
portfolio realizations.
A case in point is the familiar mean-variance
framework, in which the use of standard
deviation as a risk measure is tightly bound to the
assumption that future portfolio values are
normally distributed. Unfortunately, such
traditional approaches are awkward at best, and
at worst, begin to unravel when the underlying
assumptions are violated.
For example, the distribution of future values for
a “zero-cost” spread position is clearly not normal
and the use of return as a reward measure is
meaningless when the current mark-to-market
value is zero. As another example, the estimation
of credit risk across a group of counterparties or
sectors cannot be based on a measure that
assumes joint normality of credit losses; losses
due to default and credit migration are usually
highly skewed.
What is needed, then, is an approach that not
only deals robustly with the full range of future
possibilities, but is also backward compatible with
older technologies such as mean-variance
approaches.
Mark-to-Future focuses on simulated future
scenarios. In a simulation-based framework,
scenarios completely define the possible future
realizations of value. Only through simulation
can the choice of risk/reward measures be fully
decoupled from the estimation of future
outcomes. Bringing scenarios to the forefront is
the key to designing a flexible and extensible risk/
reward framework. Scenarios, effectively, become
the language of risk and reward.
In addition, scenarios provide a natural linkage
between risk factors that traditionally have been
treated as separate “islands” in the risk
management landscape. For example, the
integration of market and credit risk can be
achieved by defining the joint evolution of
market risk factors and credit drivers. Each
individual scenario represents a given realization
of the systemic risk factors, while idiosyncratic
risks may be modeled as realizations conditionally
independent upon the occurrence of that
scenario.
What is Mark-to-Future?
At any point in time, the levels of a collection of
risk factors completely determine the mark-to-
market value of a portfolio. Scenarios on these
risk factors determine the distribution of possible
mark-to-market values. Scenarios on the
evolution of these risk factors determine the
distribution of possible Mark-to-Future values
(MtF values) through time. Because scenarios
capture future uncertainty as time unfolds, and
because Mark-to-Future has scenarios as its key
information input, the framework enables the
calculation of future mark-to-market values that
capture future uncertainty across scenarios and
time steps.
 A call for a framework
Mark-to-Future is essentially about two things:
• Mark-to-Future is a robust and forward-
looking framework that integrates disparate
sources of risk. By explicitly incorporating
the passage of time, the evolution of
scenarios over time, and the dynamics of
portfolio holdings over time, Mark-to-Future
provides a flexible and unifying platform for
assessing future uncertainty.
• Mark-to-Future is an extensible risk
architecture that can be leveraged within a
single organization and across several
organizations. Mark-to-Future enables the
decoupling of the computationally intensive
simulation stage (the risk service) from the
post-processing risk/reward assessment stage
(multiple risk clients). It also accommodates
differing views of what the future may bring,
and different models for pricing assets and
positions, now and in the future.
A framework for risk and reward
As a risk framework for producing simulation-
based risk and reward measures, Mark-to-Future
provides the following benefits:
• Mark-to-Future is an intuitive framework.
Scenarios are the drivers of all future
uncertainty; they are the language of risk.
Individual MtF values are produced as a
direct function of a given scenario whose
characteristics can be explained in a
straightforward manner. Individuals of very
different levels of sophistication can
contribute to risk/reward discussions through
the focus on plausible scenarios.
• Scenarios on risk factors define
distributions of MtF values. As individual
risk factors can evolve jointly (and
arbitrarily) over time, Mark-to-Future can
capture the implied relationships (including
correlations) among disparate risk factors
over multiple time steps. Thus, market,
credit and liquidity risks may be integrated
within a common framework.
• The realization of MtF values over
individual scenarios and time steps
determines any risk or reward measure.
Most importantly, as we will see, the
3
framework is strictly linear across position,
scenario and time dimensions. The addition
of a new position, scenario or time step
requires only the simulation of the new MtF
values, which are then appended to the
previously computed results. Previously
simulated MtF results need not be
recalculated; only the calculation of risk or
reward measure need be repeated.
• Mark-to-Future produces risk and reward
measures that explicitly capture the
passage of time. Thus, challenging issues
such as portfolio path dependency,
settlement and reinvestment, dynamic
rebalancing and thin market effects can be
addressed effectively.
• Mark-to-Future enables multiple portfolio
regimes (strategies) to be evaluated. In
addition to the analysis of static portfolios,
the MtF Cube makes it possible to assess the
risk/reward of a portfolio with holdings that
change dynamically over scenarios and time.
An architecture for risk and reward
As a risk architecture for the efficient delivery of
risk and reward measures, Mark-to-Future
provides the following benefits:
• MtF values need only be computed once.
Thus, Mark-to-Future is efficient and the
results can be leveraged to support multiple
applications and/or risk clients.
• Mark-to-Future can be implemented
globally across an organization. The
generation of MtF values serves as the
common input to many risk/reward
applications at different levels of the
organization, from desk-level trader
applications to enterprise-wide applications.
• Mark-to-Future decouples the
computationally intensive simulation stage
from the post-processing stage. A service
bureau network can be established over
which risk services can be distributed by a
service provider to clients who need not
divulge their holdings.
• Mark-to-Future is an open and extensible
framework. The framework enables the
incorporation of new scenario generation
techniques, new pricing algorithms and new
4 A call for a framework
post-processing applications. The framework
can therefore be extended to accommodate
new business lines and to evolving risk
management practice. In no manner is it
linked or committed to any one particular
risk/reward, pricing or scenario generation
methodology.
Mark-to-Future methodology
At the core of the MtF framework is the
generation of a three-dimensional MtF Cube.
The MtF Cube is built in steps.
First, a set of scenarios is chosen. A scenario is a
complete description of the evolution of key risk
factors over time. In the second step, a MtF table
is generated for a given financial instrument.
Each cell of the MtF table contains the computed
MtF value for that financial instrument under a
given scenario at a specified time step. A
MtF Cube consists of a set of MtF tables, one for
each financial instrument of interest. Figure A.1
illustrates a representative MtF Cube.
S Scenarios
s
tep
es
im
N instruments T t
Figure A.1: Representative MtF Cube
In certain applications, a cell of the MtF Cube
may contain other measures in addition to its
MtF value, such as an instrument’s MtF delta or
MtF duration. In the general case, each cell of a
MtF Cube contains a vector of risk-factor
dependent measures for a given instrument
under a given scenario and time step. In some
applications, the vector may also contain a set of
risk-factor dependent MtF cash flows for each
scenario and time step. For ease of exposition,
however, we focus primarily on the typical case in
which each cell contains only the instrument’s
MtF value.
Key to the MtF framework is the premise that
knowledge of portfolio holdings is not required to
generate a MtF Cube: a single MtF Cube
accommodates the risk/reward assessment of
multiple portfolios simultaneously. A MtF Cube
provides a pre-computed basis that maps into all
portfolios of financial products. Since the
MtF Cube contains all of the necessary
information about the values of individual
instruments, a portfolio MtF table can be created
simply as a combination of those basis
instruments. All risk/reward analyses and
portfolio dynamics for any set of holdings are,
therefore, derived by post-processing the
contents of the MtF Cube. For example, the risk/
reward assessment of a portfolio regime such as a
roll-over strategy or an immunization strategy is
captured strictly through the mapping of the
MtF Cube into dynamically rebalanced positions.
The MtF methodology for risk/reward assessment
is summarized by the following six steps, each of
which can be explicitly configured as an
independent component of the overall process:
The first three steps build the MtF Cube:
1. Define the scenario paths and time steps.
2. Define the basis instruments.
3. Simulate the instruments over scenarios and
time steps to generate a MtF Cube.
The next three steps apply the MtF Cube:
1. Map the MtF Cube into portfolios to
produce a portfolio MtF table.
2. Aggregate across dimensions of the portfolio
MtF table to produce risk/reward measures.
3. Incorporate portfolio MtF tables into
advanced applications.
The simulation of the MtF Cube in Step 1 to
Step 3 represents the only computationally
intensive stage of the process and, significantly,
need be performed only once. These steps
represent the pre-Cube stage of MtF processing.
In contrast, Step 4 to Step 6 represent post-
processing exercises, which can be performed
with minimal additional processing (Step 4 and
Step 5) or slightly more complex processing
 A call for a framework 5

Step 1: Scenarios
Define the scenarios
and time steps Time steps

Basis instruments
Step 2:
Define the basis
instruments
Scenarios

Pre-Cube
p s
ste
MtF Cube

e
Instruments Tim
Step 3:
Simulate the instruments
over the scenarios and time steps

Step 4:
Map the MtF Cube into
portfolios/portfolio regimes
Scenarios

Time steps Portfolio

Post-Cube
MtF values
Step 5:
Aggregate portfolio MtF values
to produce risk/reward statistics

VaR, Regret, RAROC Optimal replication

Step 6:
Incorporate portfolio MtF Portfolio credit loss
values into other applications

Figure A.2: Schema of the MtF methodology

(Step 6). These steps represent the post-Cube
stage of MtF processing. Figure A.2 provides a
schema illustrating the six steps of the MtF
methodology.
The decoupling of the post-Cube stage from the
pre-Cube stage is the key architectural benefit of
the Mark-to-Future framework. A single risk
service may generate a MtF Cube (pre-Cube)
that can be distributed to multiple risk clients
(post-Cube) for a variety of customized business
applications. This generates leverage as a
common risk/reward framework and can be
widely distributed throughout the organization as
well as to external organizations for user-specific
analyses.
The six steps of Mark-to-Future
The objective of this document is to provide a
step-by-step description of the fundamentals of
the MtF framework and to demonstrate why it
represents a standard for simulation-based risk/
reward management. Mark-to-Future is a
framework designed not merely to measure risk
and reward but, significantly, to manage the
trade-off of risk and reward. The remainder of
this document is organized as follows.
Step 1 discusses the definition of scenarios. In
the MtF framework, scenarios represent the joint
evolution of risk factors through time and are,
thus, the ultimate determinant of future
uncertainty. The explicit choice of scenarios is
the key input to any analysis. Accordingly,
scenarios directly determine the future
distributions of portfolio MtF values, the
dynamics of portfolio strategies, the liquidity in
the market and the creditworthiness of
counterparties and issuers. This step discusses
scenarios in risk management, their importance,
and various methodologies used to generate
them.
Step 2 discusses the definition of basis
instruments. Portfolios consist of positions in a
number of financial products, both exchange
traded and over-the-counter (OTC). The MtF
6 A call for a framework
Cube is the package of MtF tables, each
corresponding to an individual basis instrument.
A basis instrument may represent an actual
financial product or an abstract instrument. As
the number of OTC products is virtually
unlimited, it is often possible to reduce
substantially the number of basis instruments
required by representing the MtF values of OTC
products as a function of the MtF values of the
abstract instruments. This step discusses the
issues surrounding the selection of basis
instruments to be contained in the MtF Cube.
Step 3 discusses the generation of the MtF
Cube. The MtF Cube consists of a set of MtF
tables each associated with a given basis
instrument. The cells of a MtF table contain the
MtF values of that basis instrument as simulated
over a set of scenarios and a number of time
steps. This step discusses the relationship
between risk factors, scenario paths and pricing
functions for the simulation of MtF values.
Step 4 discusses the mapping of the MtF Cube
into portfolios and portfolio strategies. From
the MtF Cube, multiple portfolio MtF tables can
be generated as functions of the MtF tables
associated with each basis instrument. Key to the
MtF framework is the premise that a MtF Cube is
generated independently of portfolio holdings.
Any portfolio or portfolio regime can be
represented by mapping the MtF Cube into static
or dynamically changing portfolio holdings. This
step discusses how portfolio MtF tables are
produced from a single MtF Cube.
Step 5 discusses the estimation of risk/reward
measures derived from the distribution of
portfolio MtF values. The portfolio MtF table
resulting from the mapping of the MtF Cube into
a given portfolio or portfolio strategy contains a
full description of future uncertainty. Each cell of
the portfolio MtF table contains a portfolio MtF
value for a given scenario and time step. The
actual risk and reward measures chosen to
characterize this uncertainty can be arbitrarily
defined and incorporated strictly as post-
processing functionality in the post-Cube stage.
Step 6 discusses more advanced post-
processing applications using the MtF Cube.
MtF Cubes may serve as input for applications
more complex than calculating simple risk/
reward measures. The properties of linearity and
conditional independence on each scenario can
be used to obtain computationally efficient
methodologies. For example, conditional
independence within a particular scenario is a
powerful tool that allows the MtF framework to
incorporate effectively processes such as joint
counterparty migration. In addition, portfolio or
instrument MtF tables may be used as input to a
wide variety of scenario-based risk management
and portfolio optimization applications.
The notation used in this book is summarized in
the Notation chapter (page 79).
Step 1: Defining Scenarios and
Time Steps
Scenarios represent the joint evolution of risk factors through time and are, thus,
comprehensive descriptors of future uncertainty. They directly determine the future
distributions of portfolio MtF values, the dynamics of portfolio strategies, the liquidity
in the market and the creditworthiness of counterparties and issuers. The explicit
choice of scenarios is the key input to a MtF analysis. This chapter discusses scenarios
in risk management, their importance and various methodologies used to generate
them.

The quality of a risk management analysis
depends on the ability to generate relevant,
forward-looking scenarios that properly represent
the future. In the MtF framework, at a point in
time, the distribution of underlying risk factors
such as interest rates, equity indices, commodity
prices, foreign exchange rates or macroeconomic
variables is defined by the set of scenarios
explicitly chosen. Thus, any desired future risk
factor distribution can be incorporated directly
into the analysis in a manner that is not
constrained by a specific summary statistic or a
single scenario generation technique. Future
distributions of portfolio outcomes are then
ultimately driven by future distributions of
underlying risk factors. The transparent
integration of various seemingly different risks,
such as market, credit and liquidity risk, can be
accomplished through the explicit introduction
of scenarios which include the factors that are
the sources of these risks.
Traditional risk/reward methodologies are based
on simplifications, often parametric, of the
description of the risk factor evolution that are
necessary to achieve mathematical tractability.
Simplifying assumptions are made despite the
fact that financial risk managers now widely
recognize the limitations of such techniques.
Scenario-based risk management analyses
overcome these limitations, but create a need for
relevant scenarios. Accordingly, in the last
decade there has been extensive research into
techniques for generating realistic and
computationally efficient scenarios for risk
management. Many of these techniques are
largely derived from major advancements in
scenario generation in both the physical and
economic sciences, starting with the
development over half a century ago of tools such
as statistical bootstrapping and the Monte Carlo
method.
This chapter defines scenarios formally, discusses
their merits, provides an overview of the
characteristics of scenarios for different risk
analyses and, finally, considers the main
techniques used to generate scenarios including
history, scenario proxies, scenario bootstrapping,
subjective opinions and model-based methods.
What are scenarios?
A scenario is the basic descriptor of the
evolution of the state-of-the-world over time. It
gives a joint realization of all the relevant
8 Step 1: Defining scenarios and time steps
financial and economic risk factors at a discrete
set of times in the future. The period of the
analysis is [0,T], where today is time t = 0 and
the time horizon is t = T. A MtF table is
constructed by valuing a financial instrument
across each of the j = 1, …, S scenarios over
t = 1, …, T time steps. The MtF value, mijt, of
instrument i under scenario j at time step t is a
function f(•) of the levels of specified risk factors
mijt = f ( u 1jt, u 2jt, u 3jt, …, u Kjt )
where u kjt = ( k = 1, …, K ) is the level of risk factor
k under scenario j at time step t. Thus, the
realization of risk factor levels over time
completely defines the future realizations of
instrument and portfolio values through time. In
advanced applications, the scenarios may
describe only the systemic realizations of
instrument values. This is further described in
Step 6.
The current state-of-the-world is the point of
departure of every scenario. Today, the current
market and economic data determine, for
example:
• the mark-to-market value of all instruments
in a portfolio
• the cash flows to be paid, received and
reinvested
• the bid-ask spreads
• the credit quality of all obligors (issuers,
counterparties, accounts) in the portfolio.
In principle, scenarios can be generated directly
on the prices of all securities (accounting for the
sizes of trades), the credit state of given obligors
and the composition of the portfolio, etc. This
would be impractical, however, for a number of
reasons. For example, to generate the scenarios,
correlations between all instruments are needed,
and each time a new instrument is added to the
portfolio, its correlation to all other instruments
must be computed. Furthermore, it is over-
restrictive because the characteristics of
instruments change through time and it is
unclear how we would construct their joint
evolution from previous historical data.
In contrast, by generating scenarios on systemic
risk factors, the estimation of models is more
robust and the use of historical simulation is
straightforward, as is obtaining the MtF value of
a new instrument that is completely consistent
with the prices of the existing instruments. Using
this approach, it is not necessary to define
explicitly the correlations among all instruments,
since the co-dependence is defined implicitly by
the scenarios.
Scenario selection differs considerably from
forecasting. A forecast is a prediction that a
single scenario will occur, and its accuracy is
therefore crucial. However, no one is able to
predict accurately specific financial events in the
future. As Nobel Laureate Paul Samuelson
observed, “analysts successfully predicted 12 out
of the last four major recessions”
(Samuelson 1991).
The goal in selecting scenarios in the MtF
framework is to span the range of future possible
events, and not necessarily to forecast that any of
these events will actually occur. Thus, in a given
risk analysis, we assume the existence of a set of
scenarios that may occur in the future. If the
scenarios set is rich enough, one of these events
will actually occur, but at the start of the period,
there is uncertainty as to which one it will be.
It is also assumed that we have a perception of
the likelihood of these scenarios. The likelihood,
or probability, pj , ( j = 1, 2, … , S ) , of a given
scenario j is not needed to compute MtF values.
Probabilities are required only at a later stage
when risk/reward statistics are computed. In
addition, the choice of scenarios need not
necessarily depend on the probability assigned to
them. This separation of probabilities from the
scenarios themselves allows MtF values to be
computed once and subsequently used as inputs
into many different risk analyses.
Scenarios must span a wide range of possible
outcomes and they must also extend over a
horizon, or multiple horizons, of appropriate
length. The length of the horizons varies with the
problem. While the appropriate horizon for a
market risk analysis might be one to 10 days (or
longer depending on the liquidity of the
position), estimating counterparty exposure
profiles may require multiple time horizons over
10 years or more.
 Step 1: Defining scenarios and time steps
Why use scenarios?
Using a scenario-based approach to risk/reward
assessment offers many advantages.
1. Accurate description of the future. A
wealth of techniques can be used to generate
scenarios from history, advanced models or
subjective views of the world. A risk
management framework based on scenarios
overcomes the limitation of standard
analytical methodologies that may require
onerous simplifications of the description of
the risk factor distributions for mathematical
tractability.
2. Transparency and communication. Using
scenarios to describe the future possible
states-of-the-world makes the risk
management process transparent, descriptive
and manageable. A thorough understanding
of scenarios is essential for good risk/reward
management. In order to interpret a risk
measure, it is important to understand the
nature of the scenarios used to produce it.
Furthermore, the end-users of the risk
information should help sanction the
scenarios. Risk managers understand
scenarios and their market experience and
intuition are key to defining them. Scenarios
allow individuals from widely different
backgrounds and perspectives to engage in
meaningful discussions on risk.
3. Integration of risks. Regulators are calling
for an integrated framework for measuring
market, credit and liquidity risk. These
disparate sources of risk are linked quite
naturally through the scenarios of the MtF
framework. The integration occurs at the
scenario level. Scenarios on simultaneous
changes in all systemic factors affecting
market, credit and liquidity states naturally
provide correlated, consistent MtF values
from which risk measures that link these
sources of risk can be calculated. Various
integrated measures of risk and return can
then be obtained, simplifying the integration
of risk/reward measurement for capital
allocation purposes.
9
4. Computational efficiency. Scenario-based
risk analyses are computationally intensive,
but scenarios can be used efficiently in the
MtF framework, which exploits some simple,
yet powerful, mathematical properties:
• Conditional linearity. Conditional on a
scenario, the value of a portfolio is a
linear function of both the value of the
instruments and the number of positions
held in each instrument. This facilitates
the fast pricing of a large number of
portfolios simultaneously as is necessary,
for example, in applications that
distribute risk management reports to
various users. This property can also be
exploited in the implementation of real-
time incremental analysis of new deals,
dynamic portfolio strategies and portfolio
optimization.
• Conditional credit independence.
Conditional on a given scenario on all
systemic factors, credit events are
independent. This property can be
effectively exploited to integrate market
and credit risk and to compute portfolio
credit capital. This is generally more
efficient than a direct simulation of
credit events.
• Conditional independence of specific
risks. Conditional on a scenario on all
systemic factors, equity prices are
independent. This can be used
effectively, for example, to evaluate the
risk of equity portfolios and determine
specific risk. Conditional independence
is indeed a general property of multi-
factor models commonly used to price
corporate bonds and other securities.
Scenarios in risk management applications
Scenarios are the critical elements of a MtF risk
analysis. Hence, they must span a wide range of
possible outcomes. In most implementations, a
distinction is made between extreme scenarios
that are used for stress testing and scenarios
based on “typical” market conditions. However,
both types of scenarios have equivalent status
10
(but not necessarily weights) in the MtF
framework. All scenarios are part of the same
consistent MtF Cube. A distinction is made only
at the post-Cube stage of MtF processing.
The choice of scenarios typically depends upon
the risk management application. Table 1.1
presents a summary of scenario requirements
(type of scenario, risk factors, horizon and
number of times steps) that depend on the risk
management area and desired application. These
are general guidelines on the characteristics of
the scenarios required, and not necessarily the
current “best practices.” In most applications
today, rigorous scenario-based risk management
is still not the norm.
In general, scenarios in market risk applications
are described by financial market risk factors that
include various zero coupon term structures,
equity indices, exchange rates, commodity prices
and implied volatilities. Typically, a market risk
analysis is performed over a single, short horizon
(one to 10 days). Term structures and volatility
surfaces are modeled with a large number of
factors (e.g., the RiskMetrics dataset contains
14 nodes per term structure). Statistical analysis,
such as VaR, requires the description of the joint
distribution of the factors at the given horizon.
Both historical and Monte Carlo scenarios are
widely used. Scenarios for asset management
applications are similar but extend over longer
horizons ranging generally from one month to
one year and may include multi-time step
simulations. Accordingly, asset managers also
customarily use factor models to reduce the
factors in their analysis to a more manageable
number.
In contrast, asset liability management (ALM)
and credit risk analyses require the generation of
scenarios over multiple steps spanning long
horizons, sometimes extending to the maturity of
all outstanding positions. An ALM analysis is
concerned mainly with scenarios describing the
evolution of interest rate risk factors (and
perhaps foreign exchange risk factors) affecting
the cash flows of trading and banking positions.
Since the values of derivatives are extremely
sensitive to the market conditions, the analysis of
counterparty credit exposures in a derivatives
trading book requires scenarios on all market
Step 1: Defining scenarios and time steps
factors affecting their value over time (Aziz and
Charupat 1998). Portfolio credit risk models, on
the other hand, are concerned with the joint
defaults and credit migrations of all obligors, and
hence require scenarios on the credit drivers that
influence obligor creditworthiness. For example,
CreditMetrics (J.P. Morgan 1997) defines
country, region and sector indices as credit
drivers for the asset value and credit quality of
each obligor.
Integration of market and credit risk through
scenarios
It is still common practice to treat market and
credit risk separately. This separation has a major
impact when measuring counterparty exposures,
portfolio credit risk and specific risk for bonds.
This is further described in Step 6.
Ultimately, a comprehensive framework requires
the full integration of market and credit risk. In
the Mark-to-Future framework, the integration
of market and credit risk is achieved through the
scenarios, which explicitly define the joint
evolution of market risk factors and credit
drivers. Market factors drive the prices of
securities, and hence exposures, whereas credit
drivers are systemic factors that drive the
creditworthiness of obligors in the portfolio.
Factors are general and can be microeconomic,
macroeconomic, economic and financial.
Consider, for example, the counterparty exposure
to a position in a corporate bond. The present
value of the bond is a function of the Treasury
curve and an additional credit spread that
compensates for the default risk of the corporate
issuer. The credit spread, in turn, depends on the
credit quality of the corporate issuer. If a credit
downgrade occurs, cash flows must be valued
using a higher credit spread. Market and credit
risk are consistently linked by incorporating all
the systemic information on the interrelated
outcomes for the issuer’s credit rating and for the
Treasury curve in the scenarios. An illustration of
integrated market and credit scenarios based on
the integrated model of Iscoe et al. (1999) is
presented on page 68.
Scenarios and liquidity risk
Although the cost of liquidity is usually reflected
in bid-offer spreads, liquidity risk can also be
 Step 1: Defining scenarios and time steps
Number of Number of
Area Factors Risk analysis Horizon Type of scenarios
time steps scenarios

Market risk 50–1,000 statistical (VaR, RAROC, risk 1–10d 1 historical 100–500
IR (government, spreads) contributions)
MC: normal and fat-tail 1,000–
foreign exchange distribution 10,000
equity stress testing (worse-case, what-if) 1–30d 1–10 extreme: historical “crashes”, 5–50
commodities subjective

sensitivity analysis (deltas, etc.) 0–1d 1 shifts in small number of factors 10–100

Asset/fund 20–500 statistical (VaR, risk contributions, risk 30d–1y 1–10 historical, bootstrapping 100–500
management IR (government, spreads) adjusted returns)
MC: multi-factor processes 1,000–
foreign exchange 10,000
equity stress testing (worse-case, what-if) 30d–1y 1–10 extreme: historical “crashes”, 5–20
commodities subjective

Asset liability 20–100 VaR (over time) 6m–30y 20–100 historical, bootstrapping 100–500
management IR (government, spreads) cash flow at risk
earnings at risk MC: multi-factor processes 500–5,000
foreign exchange
stress testing 6m–30y 20–1,000 extreme: historical “crashes”, 5–20
subjective

Counterparty 50–100 statistical: expected: “VaR” exposures” 1–30y 10–40 MC: multi-factor processes 1,000–5,000
credit IR (government, spreads)
exposures stress testing 1–30y 10–5,000 extreme: historical “crashes”, 10–50
foreign exchange subjective, scenario banding
equity
commodities

Portfolio 50–200 Capital: Expected losses, Credit VaR, 1–10y 1–30 MC: multi-factor processes 1,000–5,000
credit risk (systemic market and RAROC, risk contributions
credit factors): IR
(government, spreads), stress testing 1–10y 1–30 extreme: historical “crashes”, 5–20
foreign exchange subjective

11
equity
commodities
macroeconomic factors

Table 1.1: MtF scenarios for various applications

12
modeled indirectly by designing joint scenarios
on daily trading volumes and market risk factors
such as price and volatility (see, for example,
Yung 1999a). In such a model, portfolio positions
are liquidated conditional on the simulated
outcomes for these risk factors in each scenario.
For example, when simulated trading volumes
are high, positions are liquidated faster than
when trading volumes are low. If portfolio
holdings are conditional on scenario outcomes, it
must be possible to simulate the value of
portfolios that evolve over time. An example of
simulated trading volumes is presented on
page 44.
Joint scenarios on market and liquidity risk for
equity portfolios might include equity indices and
specific risk factors, which capture market risk, as
well as bid-ask spreads and trading volumes,
which determine liquidity risk. Joint scenarios on
market, credit and liquidity risk for emerging
market bonds, for example, may cover US
Treasury rates, credit risk drivers such as an
emerging market index, sovereign spreads and
bid-ask spreads.
Scenario generation methodologies
There are many ways to generate scenarios for
stress testing or statistical risk measurement.
Systematic scenario generation methods can be
broadly classified into historical and model-based
methods. Historical scenario generation methods
are sometimes referred to as non-parametric
methods, while model-based methods are
referred to as parametric methods. In addition to
these systematic methods, risk managers also
customarily use ad hoc or subjective methods,
which are not based directly on a model or
history but rather on experience, intuition or a
specific need. Examples of these are an opinion
that the NASDAQ will plummet 30%, a “what-
if” analysis to investigate the impact of a
100 basis point move in a GBP interest rate book,
and a sensitivity analysis of a position performed
by shocking each node in an interest rate curve
separately by one basis point.
Whichever method is chosen, with careful
analysis, and a broad view on where to seek
pertinent information, it is generally possible to
generate reasonable, forward-looking scenarios
Step 1: Defining scenarios and time steps
that span the range of possible future states-of-
the-world over the time horizon relevant for risk/
reward measurement. Ideally, the scenarios in a
risk analysis should satisfy three principles:
1. Scenarios must “cover” all relevant past
history. As Mark Twain once said: “history
does not repeat itself, but it rhymes.”
Historical scenarios satisfy this principle
directly. For model-based scenarios this
means that history must be used explicitly to
estimate the parameters of the model. Of
course, the process of determining the
relevant history is largely subjective. The
appropriateness of using one or five years of
historical data (either in a historical analysis
or to calibrate a model), depends on the
application and on the analyst’s opinion of
what periods of history are relevant.
Although theories can be applied to
determine the amount of data required for
robust estimation or to exclude (include)
outliers, in the end there is no simple formula
to determine the relevance of history for the
future and, hence, the subjective
assumptions must be made as explicitly as
possible.
2. Scenarios should also account for events that
have occurred in the past, but which may be
plausible under the current circumstances.
In the case of historical scenarios, this
requires the use of history in creative ways.
First, the history of each risk factor can be
augmented by including more distant events
from the risk factor’s own history than would
be a part of a standard, fixed calibration
period. Second, the history of one risk factor
can become a proxy for scenarios on another
factor. For model-based scenarios, certain
parameters of a model account for current
information that is not rooted in history,
such as a new political development or
special market conditions.
3. Scenario generation methods must be
validated, whenever possible, out of sample.
As an example, in the case of a market risk
analysis, the validity of the scenario set
generated yesterday can be tested by
 Step 1: Defining scenarios and time steps
comparing today’s mark-to-market values
with yesterday’s Mark-to-Future values. By
repeating this exercise over an extended
period, it is possible to determine the
performance of various methods. In the risk
management literature, this is commonly
referred to as backtesting, and has become an
important regulatory requirement. There are
various statistical backtesting methods (Basle
Committee on Banking Supervision 1997,
Lopez 1999). Note that in the case of longer
simulation horizons, out-of-sample testing
becomes more difficult, but it is still possible
to apply advanced statistical methods (Lopez
and Saidenberg 2000) and to perform some
checks and balances. Finally, in practice it is
clearly not possible to perform out-of-sample
validation of extreme scenarios for stress
testing in isolation.
In the following sections we review the basic
principles of historical and model-based methods.
Historical scenario generation methods
Historical time series over long periods reflect a
very wide range of scenarios. Since these events
have occurred previously in the market, they are
certainly candidates for possible future events.
However, significant events occur infrequently
and a long history may be required to produce a
set of scenarios that spans the possible range of
outcomes. The longer the time series, the wider
the range of possible outcomes that can be taken
into account.
Neglecting the possibility of a crash scenario is
clearly not prudent in a comprehensive risk
analysis. Yet, if only recent history is considered,
or the model is restricted to normal distributions
that do not include fat tails, this possibility will
probably be excluded. In the MtF framework, a
crash scenario can be incorporated explicitly.
Risk analyses can include both historical
scenarios to account for typical events and stress
test scenarios to account for atypical events.
For example, in the last 84 years, there have been
nine crashes in the Dow Jones Industrial Index
that exceeded six standard deviations (6-sigma)
in a single day (based upon the previous 250
business days). From historical experience, the
actual likelihood of a crash of that magnitude
occurring on any given day is 0.04%. Does this
13
mean that a 6-sigma crash is a very unlikely
historical event?
To answer this question, assume that daily
returns are normally distributed and
independent. The probability of a single 6-sigma
event on any given day is about 10-9, significantly
less than 0.04%. The probability of one event in
84 years is then about 0.002%.; the probability of
nine 6-sigma events occurring in 84 years is
about 10-43. Whereas according to history, 6-
sigma events are rare, a simple parametric model
grossly underestimates their probability.
In established markets where no fundamental
shifts in the underlying structure have recently
occurred, a long history may be an adequate
source of scenarios describing typical market
conditions. However, shifts can and do occur and
the future is sure to contain events outside this
range. When history is the sole source of
scenarios, it is implicitly assumed that between
now and the horizon there will be no
fundamental shift in the underlying forces in the
market, other than those already observed during
the historical period chosen. This precludes the
incorporation of new views that could be
extracted from other events or by other
techniques.
Consider a second example. At the end of
March 1998, the Canadian dollar was trading at
approximately 0.708 USD. The Canadian dollar
had last touched 0.700 USD in 1994. A risk
analysis of a portfolio with Canadian dollar
exposure based on a standard historical time
series would have provided a false sense of
security to the holders of that portfolio. In fact,
the drop in the Canadian dollar from 0.708 to
0.633 USD that occurred between March and
August 1998 represented a three standard
deviation move with about a 0.02% likelihood of
occurring. (The standard deviation of daily log
returns with zero mean is calculated based upon
one year of daily observations between
March 1997 and March 1998 and scaled to a
five-month horizon by the square root of time).
Beyond that, how would we understand the risk
or return of a stock that has not yet been issued
or of the euro before it became a traded currency?
How can we measure the risk of Internet stocks
when there is insufficient history in this market
on which to base historical scenarios?
14
In situations such as these we must go beyond
the history of the risk factors in order to generate
future events that reasonably span the range of
possible outcomes. One way to add to the history
During World War II, a team of three
eminent professors was asked to make long-
range weather forecasts for the Air Force. It
did not take them long to realize that they
had no idea how to go about this, but one of
them remembered that each year the
Farmer’s Almanac published detailed and
somewhat reliable predictions of the
weather for the upcoming year.
Unfortunately, when the professors asked
how the Almanac made the weather
prediction, the publisher refused to say!
Rebuffed but inspired, the professors set
about to reverse engineer the process and
find out how the Almanac’s predictions
were made. After some effort, they were
convinced they had figured it out: to
generate a forecast for, say, the year 2001,
the summer of 1954 was combined with
the fall of 1973, the winter of 1937 and
the spring of 1982. By combining events
that had actually occurred they were able to
generate a plausible forecast for 2001.
Bootstrapping was born when numerous
such forecasts were generated randomly,
creating a scenario set of weather forecasts.
of a market is to use the history for similar
situations in different markets as a proxy.
Scenario proxies and bootstrapping
If standard historical methods would not have
captured the exchange risk in the Canadian
dollar in March 1998, what methods might have
been used to determine the six-month risk in the
CAD/USD exchange rate? Novel scenarios on
future Canadian dollar rates for August and
September 1998 could have been extracted from
an AUD/USD time series. Using the AUD/USD
exchange rate as a proxy for the scenarios on the
CAD/USD rate could have been justified on the
basis of perceived similarities between the
Australian and Canadian macroeconomic
conditions at that time. Several times over the
Step 1: Defining scenarios and time steps
last decade, for example in 1987, 1989 and 1993,
the exchange rate on the Australian dollar
dropped by 10% or more within a short number
of months. Scenarios on the AUD/USD
exchange rate would have provided a sensible
forward-looking view of future Canadian dollar
behaviour, including a Canadian dollar scenario
describing a drop to 0.633 USD or below.
A useful way to address the sentiment or
economic environment of a given market is to
look for history in a different market or region
that may have gone through similar situations in
the past. We then take these conditions and apply
them today as scenarios on the desired market.
Such scenarios are generally called proxies.
Consider Brazil as another example. Early in
1999, market risk managers in Brazil asked, “How
can we calculate Value-at-Risk figures for our
portfolios when we don’t have any historic data?”
(Locke 1999). One possibility would have been
to consider the market turbulence caused by the
devaluation of the ruble in August 1998 as a
proxy for how events in Brazil might unfold
should the real be allowed to float (Yung 1999b).
Bootstrapping can be performed in more
sophisticated ways to obtain conditional
scenarios. For example, high volatility scenarios
can be generated by sampling repeatedly from a
history filtered to exclude periods of low
volatility.
Bootstrapping can also be used in conjunction
with scenario proxies. Previous markets that have
enjoyed exceptional growth, Nokia A stock (an
emerging industry) and the gold rush in the
1970s, can serve as proxies for upside scenarios to
determine the risk in a position in a new Internet
stock (Yung 1999c). The 1929 stock market crash
that precipitated the Great Depression, and
Black Monday of October 1987 can serve as
proxies for downside scenarios. Bootstrapping can
then be used to scramble and rearrange daily
returns from the applicable proxy periods. Further
randomization can be achieved by randomly
selecting the starting point for a scenario series.
Model-based scenario generation
Research in computational finance over the last
decade has resulted in powerful models for
scenario generation applicable to risk
management. By adding theory and structure to
 Step 1: Defining scenarios and time steps 15

Proxies—Brazil’s Real Crisis

In January 1999, US-based
investors were keenly
interested in understanding
how events in Brazil might
unfold should the real be
allowed to float: devaluation
of the real by the central bank
would cause the rates on
Brazilian Brady bonds to soar.
Just as the Russian ruble
devaluation was the catalyst
for market turbulence in
August 1998, might pressure
building up behind the real Devaluation of the ruble
have a similar impact in
January 1999?

Parallels to Russia
In August 1998, Russia
announced the devaluation of
its currency and temporary
default on its government
debt. Russian stocks fell by Brady spreads US 30-year Treasury rate
more than 35% while the ruble
tumbled by more than 50%. Changes in key rates (August 14–28, 1998)

Yields on emerging market

debt soared, including those financial markets were History repeats itself
on Brazilian Brady bonds, feverish. Credit spreads
while those on US Treasury widened, equity markets Using the period of the ruble
bonds reached historic lows. declined, volatility increased devaluation as a proxy for
Spreads on the Russian and bid-offer spreads on current market scenarios, the
Ministry of Finance emerging market debt widened two weeks from August 14 to 28,
Venesheconombank bonds precipitously. 1998 become two weeks in
doubled from their usual norm
and the US Treasury zero
curve dropped by more than
6% from August 14 to 28. The
flight to quality that
commenced as investors RUSSIAN CRISIS BRAZILIAN CRISIS
rebalanced their portfolios
US Treasury zero rate (August) US Treasury zero rate (January)
caused liquidity in emerging
markets to evaporate. Brazilian Brady bond spreads Brazilian Brady bond spreads
(August) (January)
Once confidence in Russia
waned, capital fled and
Mapping the ruble to the real
16 Step 1: Defining scenarios and time steps

January 1999: the US Treasury

VaR zero rate and the Brazilian Brady
bond spread for those
10 business days are mapped to
the US rate and the Brazilian
Brady spread (respectively) from
Actual January 11 to January 25.
Compared to the 95% VaR
Russian stress test
estimate, the extreme event
proxied by the Russian scenario
confirms suspicions of the
magnitude of the potential
risk—it forecasts a 57% decline
in portfolio value over this two-
Devaluation of the Ruble Details of Russia’s
debt restructuring
Russia’s central bank
yielded support of
week period. This estimate
program announced the Ruble foreshadows the actual
behaviour of the Brady portfolio.
Evolution of portfolio value (January 11–26, 1999)
Brazil experienced a de facto
devaluation of its currency on
January 12 when the central
bank stopped defending the real.
On January 15, 1999, the
Brazilian government let the real
Actual
float and raised interest rates;
investors’ relief at the
government’s responsiveness to
the crisis is evident from the
actual behaviour of the Brady
Russian stress test portfolio. This sentiment was
comparable to that felt by
investors when Russia
announced the details of its
debt-restructuring program on
August 24, 1998.
Impact of government intervention (January 15–26, 1999)
 Step 1: Defining scenarios and time steps
the way scenarios are generated, these models
allow us to
• extend what has been observed, using all the
historical and “current event” information
available
• generate a large number of scenarios in the
sample that can lead to reliable statistical risk
measures
• move from a mere description of what could
happen to an explicit explanation of
correlations and causality that explains the
sources of risk
• construct tools for forecasting and for the
computation of conditional events.
Models of the evolution of financial risk factors
are used for both pricing of derivative securities
and risk management. However, the models
traditionally built for derivatives pricing may not
be appropriate for risk management for various
reasons:
• Risk management scenarios must use the true
probabilities of events and are calibrated
using history and current event information.
In contrast, pricing models generally use
what are commonly called the risk-neutral
probabilities. This is a mathematical
convenience that allows the direct
incorporation of a no-arbitrage condition
while expressing the price of a derivative as
an expectation. These models are calibrated
to fit current available prices of traded
securities.
• Risk management scenario generation
models are generally high dimensional. Since
the emphasis is on understanding the joint
behaviour of many instruments in a portfolio,
they must incorporate the relationships
between all factors. Pricing models, on the
other hand, generally use a small number of
factors; for example, most implementations
of term structure models use one or two
factors. Also, since they are used to price
single securities, these models usually do not
incorporate the relationships to other factors.
• Risk management focuses generally on the
tails of portfolio distributions; this is where
the action is for a risk manager! Hence, a
17
strong emphasis on modeling tails is required.
Pricing derivatives, on the other hand,
requires the computation of expectations of
distributions and may be less concerned with
extreme events.
As with pricing models, however, risk
management scenario generation models must be
financially consistent and build on existing
mathematical and financial theory. For example,
a model for interest rate scenarios that permits
negative forward rates would permit static
arbitrage and could result in unreasonable MtF
values for certain securities.
A scenario generation model consists of three
separate parts:
1. The risk-factor evolution model is a
mathematical model that describes the joint
evolution of the risk factors in the future.
The model is chosen for its mathematical
tractability, the underlying financial theory,
its asymptotic properties and its ability to
explain causality, as well as other scientific
and aesthetic properties of good modeling.
2. The model calibration method refers to the
methodology used to estimate the parameters
of the model. Generally, models are
calibrated using historical information,
incorporating current events and using the
experience of the modeler.
3. The sampling methodology is used to obtain
random samples from a model. The objective
of scenario generation in risk management is
not to provide a single forecast of the risk
factor levels in the future. Rather, we require
methodologies to sample various scenarios,
generated according to the evolution model,
and assign probabilities to them. Thus, at the
heart of model-based scenarios is the
generation of random numbers. Note that, in
addition to sampling randomly from a model,
it is possible also to sample specific likely
scenarios, extreme events and conditional
scenarios on the realization of a small
number of variables.
The most general method for sampling a large
number of random scenarios from a model is the
Monte Carlo method. Monte Carlo simulation is
18 Step 1: Defining scenarios and time steps

Proxies and Bootstrapping—Amazon.com

in the US, its stock enjoyed
growth akin to what Internet
stocks are experiencing today:
the Nokia A share trading in the
NYSE has risen by more than 20
times its value since January
1994. The gold rush in the late
1970s also has uncanny
similarities: when the US Federal
Reserve Board reduced interest
rates in response to a threatened
debt default by Mexico in 1979,
the price of gold took off, rising
AMEX Internet Index vs. S&P 500 (Jan. 1998–Mar. 1999) 300% in six months.

The impressive 34% return of Comparison of Nokia A in

the S&P 500 since January 1994 and AMEX Internet
Index in 1998
1998 pales in comparison to
the performance of Internet
stocks. The AMEX Internet
Index, which tracks 50 such
stocks trading on the New
York Stock Exchange, rose by
more than 200% during the
same period. Gains
experienced by blue-chip
Internet stocks were even
more significant. Overall,
a) Nokia A shares (Jan. 1994–Mar. 1999) vs.
share values of companies like AMEX Internet Index (Mar. 1998–Mar. 1999)
Amazon.com, Yahoo!, eBay Comparison of Gold
and AOL have grown by more (1979–1980) to AMEX
than 1,000% since the start of Internet Index (1998–1999)
1998. Internet stocks have
experienced exceptional
growth. A position of five
million shares in Amazon.com
purchased in early 1988 was
worth only 65 million USD; a
year later that position was
worth 700 million USD.
Have previous markets
enjoyed growth similar to b) Price of gold (Jun. 1979–Mar. 1999) vs.
Internet stocks today? When AMEX Internet Index (Mar. 1998–Mar. 1999)
Nokia first entered the
telecommunications industry Prices of Nokia A and gold vs. AMEX Internet Index
 Step 1: Defining scenarios and time steps 19

1929 Stock Market Crash 1980 Gold Crash

(Dow Jones Industrial 1925–1935) (Gold prices 1973–1999)

Black Monday of October 1987 Japanese Stock Market Crash in 1990

(Dow Jones Industrial 1985–1990) (Nikkei 225 1981–1999)

Various stock market crashes

Mark the position to future
The three-year period
following each historic market
peak serves as the proxy for
downside risk while the one-
year period that precedes each
historic market peak serves as
the proxy for further growth
scenarios.
Downside scenarios are
bootstrapped using daily
returns generated from the
downside proxies, upside
scenarios are bootstrapped
using daily returns generated
from the upside proxies, and
volatility scenarios are
bootstrapped by combining
returns from the upside and
downside proxies. This process
creates a set of 200 scenarios
over a horizon of 100 days.
Assuming a hold strategy, the
Mark-to-Future values of one
share of Amazon.com indicate
that the stock can potentially
gain 120% in the next 100
days. However, it can also lose
more than 85% over the same
period. This translates into a
loss of more than 587 million
USD in just five months on a
position of five million shares!
Would a trading strategy
mitigate risk? Five million shares
represent 10% of Amazon.com’s
total market float. The average
daily volume for Amazon.com is
only seven million shares; it is
common for daily trading
volume to be as low as 10% of
average volume. This lack of
liquidity poses additional
concerns—instantaneous
disposition of the entire holdings
is not likely. A stress test model
must forecast the risk specific to
the Amazon.com shares, as well
as the risks of trading in this
illiquid market.
20
The impact of liquidity (the next 100 days)
To account for a light trading
day in which daily volume is
limited to 700,000 shares, the
strategy is conditioned on the
movement of the
Amazon.com share price.
Whenever Amazon.com falls
below 10% of its current value,
Step 1: Defining scenarios and time steps
the position size is decreased
by 250,000 shares. When the
price drops below 20% of its
current value, the disposition
of shares is increased to
500,000. For simplicity,
proceeds from the sale remain
as uninvested cash.
Two bid/ask spread curves depict
normal and extreme liquidity
risks. The first curve portrays
limited liquidity risks by
assuming that sales can be
transacted without moving
market prices by more than 20
basis points. The second curve
portrays a scenario of high
liquidity risk corresponding to a
discount of 20% to the market
price of Amazon.com for a
trading volume of 700,000
shares.
The dynamic trading strategy
yields benefits. Under the worst
downside scenario, the hold
strategy forecasts a potential loss
of 85% over the next 100 days.
By locking in some of the gains,
potential losses are limited to
28% under normal liquidity
conditions and 38% in a highly
illiquid market.
 Step 1: Defining scenarios and time steps
the most widely used methodology but, generally,
it is not computationally efficient. For example,
it is not uncommon for the portfolio of a bank or
an insurance company to contain several
hundred thousand positions, including
substantial volumes of derivative products such
as swaps, caps and floors, swaptions and
mortgage-backed securities. A full Monte Carlo
simulation of a large and complex portfolio
containing such instruments is computationally
expensive, and may not even be achievable
within a reasonable time.
Various computational methodologies have been
developed to make the Monte Carlo method,
which uses pseudo-random numbers, more
efficient for various applications. These
methodologies, commonly referred to as variance
reduction methods, include antithetic variables,
control variates, importance sampling, stratified
sampling and quasi Monte Carlo methods.
Most of the financial literature has focused on
the application of variance reduction methods
for pricing (e.g., Boyle 1977, Boyle et al. 1997,
Ackworth et al. 1997, Broadie and
Glasserman 1997, Caflisch et al. 1997, Paskov
and Traub 1995, Schoenmakers and
Heemink 1997). Some of these tools do not
provide advantages for risk management in
practice because of the high dimensionality of
the problems and the required focus on the tails
rather than on the expected value. However,
several methods have proven advantageous.
Applications of stratified sampling, control
variates, important sampling and quasi Monte
Carlo methods have demonstrated performance
improvements in a number of risk management
applications (e.g., Jamshidian and Zhu 1997,
Shaw 1997, Kreinin et al. 1998a, 1998b,
Cardenas et al. 1999). For example, Kreinin et
al. (1998a, 1998b) show that quasi Monte Carlo
methods, in conjunction with principal
component analysis, compute VaR an order of
magnitude faster than standard Monte Carlo
simulation. An example of quasi Monte Carlo
methods coupled with principal component
analysis is given in the sidebar.
Risk factor evolution models
If the simulation requires only one step, as may
be the case in many market risk and portfolio
management applications, then risk factors can
21
be modeled as random variables. The model
describes the future distribution of those random
variables at the horizon.
A model of the joint distribution of the random
variables must realistically describe
• the marginal distribution of each variable
• the co-dependence structure of all variables.
The introduction of computers in the late
1940s stimulated the development of
mathematical methods that employ random
numbers. A mathematician at Los Alamos,
Stanislav Ulam, was one of the first to
realize that they would allow computations
on a sufficiently large scale to be useful for
engineers and scientists designing nuclear
bombs. In 1947, Ulam and Princeton
mathematician, John von Neumann,
proposed the use of computers to apply a
statistical approach to physics calculations.
The story goes that the name “Monte Carlo”
was given because “Ulam had an uncle who
would often borrow money from relatives
because he just had to go to Monte Carlo to
visit their famous roulette wheels”
(Peterson 1998). The name is now
commonly used to refer to any mathematical
method that employs statistical sampling
and random numbers.
An efficient and flexible method of modeling the
joint distribution of a large number of financial
variables is to model the marginal distribution of
each variable separately and then construct a
model of the co-dependence structure (Carillo et
al. 2000).
Traditional applications assume that the joint
distribution of financial returns is described by a
multi-variate normal or log-normal distribution.
This means that the marginal distribution of all
variables is normal and the co-dependence
structure is defined in its entirety by the
correlation matrix of all the variables. These
distributions are also easy to estimate from
historical data. Some advanced estimation
methods that have proven quite popular in
practice include exponentially weighted moving
averages (Longerstaey and Zangari 1996) and
GARCH (see, for example, Bollerslev 1986 and
Engle and Mezrich 1995).
22 Step 1: Defining scenarios and time steps

Monte Carlo and Quasi Monte Carlo Methods

Standard Monte Carlo (MC)
methods draw random samples 1
from the distribution using a 0.9
pseudo-random number 0.8
generator. By contrast, quasi 0.7
Monte Carlo (QMC) methods 0.6
use deterministic points 0.5
generated from a type of 0.4
mathematical vector- 0.3
sequences called low 0.2
discrepancy sequences (LDS). 0.1
The idea behind QMC 0
techniques is that by choosing 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
points in the risk factor space (a) Two-dimensional pseudo-random points
more evenly, the number of
scenarios necessary to achieve
1
a desired level of accuracy in
0.9
pricing and risk calculations is
0.8
reduced. 0.7
QMC methods have a strong 0.6
intuitive appeal for risk 0.5
management problems. Low 0.4
0.3
discrepancy sequences
0.2
specifically attempt to cover
0.1
the space of risk factors 0
“evenly,” thus avoiding the
clustering usually associated 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
with pseudo-random sampling. (b) Two-dimensional Sobol sequences
Sampling evenly seems to be a
desirable property not only
when estimating the average Pseudo random points vs. Sobol sequences
of a distribution, as required
for options pricing, but also
sequences of points that satisfy algorithms for generating the
when searching for
the property that their sequences are far from trivial. A
exceptional cases in the tails.
elements evenly cover the detailed explanation of the
Low discrepancy hypercube. The measure of solutions and algorithms is found
how evenly a sequence of in Sobol (1967) and Niederreiter
sequences points covers the region is (1992).
called discrepancy; the more
If d is the dimension of the A sequence would cover the
evenly the points are
space of independent risk hypercube uniformly if the
distributed in the region, the
factors, then sampling number of points in any possible
lower the discrepancy. Hence,
methods generally sample subset of the hypercube were
these sequences have been
from a unit d-dimensional proportional to the volume of
termed low discrepancy
hypercube. Whereas MC the subset. Discrepancy
sequences.
methods are based on points measures the worst deviation
randomly generated from the Although the idea behind between the volume of the
hypercube, QMC methods are LDS is simple, the subset and the fraction of the
based on deterministic mathematical theory and the number of points in the subset
 Step 1: Defining scenarios and time steps
over the total number of
points, over all possible
subsets.
Sobol points cover the hyper-
cube more uniformly than do
the randomly generated
points. Thus, the discrepancy
of the Sobol points is lower
than that of the pseudo-
random points.
Advantages and
disadvantages
The main advantages of
standard MC methods are
• they are generally
applicable to all problems
• their rate of convergence
is independent of the
dimensionality of the risk
factor space
• they are very popular and
their properties are well
known
Quasi Monte Carlo VaR
Quasi Monte Carlo (QMC)
methods have proven to be
useful tools both to compute
the distribution of future
portfolio values and to measure
VaR, resulting in
computational savings when
compared to standard Monte
Carlo (MC) methods based on
pseudo-random sampling
To illustrate this, we compare
the performance of the MC
and QMC methods to measure
VaR for a simple multi-
currency test portfolio. Details
of the methodology are given
in Kreinin et al. (1998a,
1998b). The accuracy of the
estimations is measured with
respect to the “true” UP&L
distribution of the portfolio,
which is computed with
• they yield probabilistic
errors and a priori bounds
on VaR estimates.
The main disadvantages of
MC methods are
• they use pseudo-random
number generators that
tend to generate clusters
of points
• they do not explicitly
exploit particular features
of the problems
• their rate of convergence
is slow.
The advantages of QMC
methods are
• they are based on
sampling techniques that
generate points evenly
within the region and
avoid the clustering
generally associated with
MC methods
negligible error using a very
large number of MC scenarios.
The test portfolio is part of a
suite of benchmark test data
(Marshall and Seigel 1996).
The mark-to-market of the
portfolio is 357.3 million USD.
It contains 14 positions in
fixed-rate government bonds
in maturities ranging from
182 days to 10 years in five
currencies: USD, DEM, FRF,
ITL and JPY. The zero curves
in each currency are modeled
using 16 node points, except
for the JPY curve which has 15
nodes. Market data is as of
September 26, 1997. We
assume that the vector of 83
risk factors is log-normal with
zero mean and covariance
matrix as published by
23
• they have been well-tested
in the non-financial and
financial literature (for
derivatives pricing).
The main disadvantages of
QMC methods are
• their lack of generality when
compared to MC methods
means that their
effectiveness may be largely
dependent on the problem,
and extensive testing is
required
• they do not yield
probabilistic errors or a priori
bounds on VaR estimates
• their rate of convergence
depends on the
dimensionality of the risk
factor space, d
• they may be inefficient for
problems in very large
dimensions.
RiskMetrics on that day
(Longerstaey and Zangari 1996).
The portfolio “true” one-day
VaR is a function of the VaR
level, α. The true VaR is
calculated using a very large
number of MC scenarios (over
800,000). Hence the sampling
errors are negligible. From these
results, the one-day 95% VaR is
4.81 million USD.
To assess the speed-ups possible
with QMC simulation, we
compare the number of scenarios
required to achieve a given
accuracy in VaR with MC and
QMC methods. Since MC
scenarios are random, the
number of scenarios required to
be within, for instance, a 2%
sampling error from the true VaR
is itself a random number. One
random simulation may achieve
24
Time VaR vs. level of confidence
2% accuracy in 5,000 scenarios
while a second random
simulation might take 5,500
scenarios.
Hence we can talk, for
example, of the expected
number of scenarios or of the
number of scenarios required to
be 95% certain that we are
within a 2% sampling error.
These numbers are determined
over many different MC
simulations. In contrast, the
QMC method is deterministic
and there is no notion of
confidence levels on the
number of scenarios.
For a 2% VaR error, the
effective number of QMC
scenarios is 2,048 and the
speed-up is 6.7 times
(compared to the MC
simulation at a 95% confidence
level). That is, the QMC
method requires almost seven
times fewer scenarios to
compute a 95% VaR with a 2%
sampling error, compared to
the MC method at a 95%
confidence level. Five out of
100 times, a MC simulation
with roughly seven times more
scenarios will yield a worse VaR
estimate than can be achieved
by the QMC method.
The QMC method becomes
less effective as a lower
accuracy is required. For
example, within a 5% sampling
error, the speed-up is only 2.1
times.
Step 1: Defining scenarios and time steps
As this example shows,
however, the QMC method
provides substantial speed-ups
for VaR calculations compared
to MC methods. Although the
QMC method generally
outperforms the MC method, it
provides greater benefits when
higher accuracy and a higher
VaR percentile are required.
For example, the speed-up for a
VaR calculation with 2%
accuracy increases from 6.7 to
9.4 to achieve a 99%
Confidence
Level, α
95%
99%
Sobol vs. mean N and 95%N for 2% error
confidence level as opposed to a
95% level in the tails. This is only
one example, but the results are
fairly characteristic of practical
applications to real portfolios.
Increased performance with PCA
tools
Although the advantages of
QMC methods are clear for
problems of moderate
dimensionality, their benefit to
high dimensional problems is a
topic of active academic debate
(Caflisch et al. 1997). Low
discrepancy sequences usually
work better in low dimensional
spaces because their discrepancy
depends on the dimension of the
space. Hence, there is a strong
motivation to reduce the
dimensionality of the risk factor
space before sampling.
Kreinin et al. (1998b)
demonstrate that principal
component analysis can be used
to reduce the dimensionality of
the problem. They find that by
using portfolio principal
components, the speed-ups can
be up to 27 times faster for the
same example!
Error, ε
2% 5%
6.7 2.1
9.4 2.7
 Step 1: Defining scenarios and time steps
Distribution Models With Fat Tails
Commonly used pricing and
risk measurement models
assume for simplicity and
mathematical tractability that
the returns of financial risk
factors follow normal
distributions though the main
objective of such models is to
measure the possible losses in
the tails.
We illustrate two practical
models with fat tails and
compare the results to the
historical observed returns and
a simple normal model, using
the JPY/USD exchange rate as
our example.
Historical distribution and
normal model
First, consider the historical
daily log-returns of the JPY/
USD exchange rate from
January 26, 1981 to January
20, 2000. For a US investor
with 100 USD = 10,547 JPY,
a decrease (increase) of one
standard deviation in the
exchange rate results in a gain
(loss) of 0.73 (0.72) USD. A
historical simulation results in
values of P&L in the range
[–8.12, 4.01] USD.
The normal distribution
closely matches the two first
moments. Clearly, the
historical distribution has
fatter-than-normal tails, which
is confirmed by the large
kurtosis. The largest negative
return in the sample
corresponds to a move of more
than 10 standard deviations,
whereas the highest positive
return is almost six standard
deviations. Under the normal
model, the probability of a six-
standard deviation move is
Historical returns on JPY/USD and normal distribution
slightly less than 10–9 and the
chance of a 10-standard
deviation move is less than
one over the number of atoms
in the entire universe!
For the US investor, the model
with a normal distribution
predicts a VaR at the 99%
confidence level of 1.69 USD,
while the historical simulation
VaR is 2.18 USD.
Mixtures of normals and
extreme value distributions
Next, consider two models
that better describe the fat
tails.
The mixture of normals
model (MN) assumes that
with probability p1 the
distribution is normal with
mean µ1 and variance σ 12 , and
with probability p2 = 1 – p1
the distribution is normal with
mean µ2 and variance σ 22 . The
parameters can be estimated
from the historical data.
Besides fitting the historical
observations better, the MN
25
model can be interpreted as the
mixture of a “normal” economic
regime, which occurs most often,
and a “stressed” regime of high
volatility, which occurs
infrequently. Based on the data
in this example, the model
suggests a “normal market,” with
annualized volatility of slightly
less than 7%, that prevails about
82% of the time and a “highly
volatile market,” with a volatility
of almost 24%, which occurs
almost 18% of the time.
While the MN model is a mixture
model, the second model is a
sum model. Roughly speaking,
the normal plus Weibull model
(N+W), fits a normal
distribution to the “central part”
of the returns histogram and a
Weibull distribution to the
“tails.” The model estimates
from the data the point at which
the tales begin and the central
part ends (e.g, at the 95th-
percentile).
Looking more closely at the left
tail of the distributions, we
observe that the normal model
assigns virtually no probability to
returns of –3 and lower, which
26 Step 1: Defining scenarios and time steps

As there were no historical

Mixture of normals and normal plus Weibull distributions for JPY/USD
occurred historically about
three times every 1,000 days.
Both the MN and N+W
models give a reasonable
weight to such an event (0.4%
and 0.94%, respectively). The
MN model assigns heavier
weights in the tail to log-
returns of up to about –5%
(for example, it assigns
likelihoods of .07% and .01%
to log-returns of –4% and –
5%, respectively). Under the
normal model a move of –4
occurs about once every
200,000 years (as opposed to
about once every six years as
predicted by MN).
eight standard deviations) has
a likelihood of 0.4%, which
corresponds to about once
every 17 months (and not
once every six trillion years as
predicted by a normal model!).
Normal
Historical
Mixture of normals
Normal + Weibull
returns beyond –7.8% during the
observation period, it is difficult
to assign any likelihood to events
beyond that point. Extreme
value theory allows us to explore
extreme events that have not yet
occurred by asymptotically
approximating the tail. For
example, under the N+W
model the likelihood of the log-
returns being –8% or lower is
about 0.1%. A rare event
indeed, but not a zero-
probability event.
In this example, the difference
between the models is not great
at the 95% level, the normal
model grossly underestimates the
99% VaR and the difference in
the 99.9% VaR in all models is
considerable.
Confidence level
95% 99% 99.9%
1.21 1.69 2.2
1.22 2.20 3.75
1.01 2.33 3.79
1.25 2.03 5.06

Note that on two occasions VaR for a US investor using different models
the returns from the
observation period fall below
–5%. Although the MN model
captures the tail fairly well, it
may still underestimate the
probability of an extreme
event because the marginal
distribution in the tail is still
approximately normal. In
contrast to the MN model, the
N+W model gives about eight
times and almost 50 times
higher probability to moves of
–4% and –5%, respectively.
Under the N+W model, a
move of –6% (which
corresponds to more than Tails of the distributions
 Step 1: Defining scenarios and time steps
However, it is widely recognized that, in many
cases, the normal distribution does not describe
financial returns accurately and that their joint
behaviour is also more complex than can be
described by the correlations. To address this
problem, a number of models have been
developed and tested that capture the nature of
financial returns better and describe the tails of
their distributions more accurately. These models
include multi-factor t-distributions, mixtures of
normals, lambda distributions, distributions from
extreme value theory summed with the normal
distribution and non-parametric marginal
distributions (see, for example, Hull and
White 1998a, Shaw 1997, Carillo et al. 2000,
Embrecht et al. 1998). Distribution models that
capture fat tails can be effectively incorporated
into a MtF simulation framework and lead to
more accurate risk measurement and
management (see page 28). In summary, these
models
• permit more accurate risk measurement and
management than commonly used normal
distributions
• provide a better statistical description of the
tails of the distributions and of extreme
events with low probability than pure
historical simulation methods.
Most traditional applications use a correlation
matrix to describe the co-dependence structure
of the risk factors. Correlations fully describe the
co-dependence structure of random variables
when the distribution is normal, or more
generally when the distribution is elliptic.
(Another example of an elliptic distribution is
the t-distribution.) However, when the
distribution is not elliptic, there are better
descriptors of the co-dependence such as rank
correlations and copulas Embrecht et al. (1999).
Copulas—probably the most general way of
modeling the joint behaviour of random
variables—have been well-researched in recent
years. The description of these tools is beyond
the scope of this document.
In contrast to the single-step problem, a multi-
step MtF analysis is required when measuring
counterparty credit exposures, for ALM, when
analyzing dynamic portfolios, etc. (see Table 1.1
on page 11). In this case, the risk factors are
27
modeled as random processes which describe the
evolution of a random variable through time.
Models of random processes have been widely
used in finance and, specifically, in derivatives
pricing. For example, the Black-Scholes model for
option pricing (Black and Scholes 1973) assumes
that the stock prices follow a process called
geometric Brownian motion (GBM).
As with normal distributions in the single-step
case, GBM models are commonly used for both
pricing and risk management because of their
simplicity and mathematical tractability, though
they do not describe real processes accurately. To
describe the evolution of interest rates, more
sophisticated models that account for mean
reversion are used. In mean-reverting models,
when the level of an interest rate becomes too
high or too low, a force pulls it back to its mean,
or equilibrium, level. Models with mean
reversion have been used widely for pricing
interest rate derivatives (e.g., Cox et al. 1985,
Hull and White 1990, Black and Karasinski
1991, Black et al. 1990). For risk management
purposes, multi-factor models are generally
required to capture the joint evolution of term
structures (see page 28).
In general, different types of assets have different
characteristics and hence a combination of
processes is required to model accurately their
evolution into the future. For example, in
addition to GBM and mean-reverting diffusion
processes, one can add processes with jumps and
(reflecting) barriers. For example, a complex
model is required to simulate electricity spot
prices (see page 30).
The models discussed above are generally
described in terms of continuous time models and
the equations used to characterize them are
called stochastic partial differential equations
(e.g., Karatzas and Shreve 1994). There are also
discrete time models, mostly from the
econometrics literature (e.g., Kim et al. 1999).
These models are commonly used to include
auto-correlations and other non-Markovian
structures.
Continuous time models have been used in
finance for the last 30 years (Sundaresan 2000).
They are generally mathematically tractable, and
28
Multi-factor Statistical Term Structure Model
A statistical model with mean
reversion for the evolution of
the term structure of interest
rates produces realistic future
scenarios over long horizons
Reimers and Zerbs (1999).
Scenarios over long horizons
are realistic when observed
rates, prices and exposures
over time are consistent with
the predicted distributions of
the model.
The model
We assume that the term
structure of interest rates is
described by n rates and that
joint movements of the
logarithms of the n rates occur
only within a k-dimensional
subset of the n-dimensional
directions, where k is smaller
than n and the n directions are
independent.
Let the term structure of
interest rates be defined by a
set of discrete rates,
r i, i = 1, 2 , …, n and let
yi = log ( r i ) . We assume that
as time evolves, each rate r i
∞
reverts to a target value r i ,
which remains constant over
time.
We assume there are k
independent state variables,
x 1, x 2, …, x k , k < n that
explain the movements of the
log rates, y i . Each state
variable follows an Ornstein-
Uhlenbeck process (Karatzas
and Shreve 1994):
Step 1: Defining scenarios and time steps
dx j = – a j x j dt + σ j dz j
j = 1, 2, …, k
where a j specifies the mean-
reversion speed, σ j specifies
the instantaneous volatility
and dzj represents a Brownian
motion. The volatilities and
the mean-reversion rates are
constant through time.
The log rates are
reconstructed by
∞
k
yi = yi + ∑ bijx j
j=1
i = 1, 2 , … , n
where B = [bij]. The columns,
B j , of the matrix B are
orthonormal vectors. Here,
the columns of B are the first k
principal components of the
changes in log rates.
The individual rates are given
by
Principal component of daily log rates
ri = e
yi
The model is calibrated using
historical data. The calibration
procedure obtains the target
∞
structure r i , i = 1, …, n ; the
state variables x j , j = 1, 2, …, k
(through the calculation of the
matrix B); and for each state
variable, x j , j = 1, 2 , …, k the
mean reversion speed a j and
instantaneous volatility σ j .
Example
The model is calibrated to US
Constant Maturity Treasury
yields (US Federal Reserve
Board 1999) in a historical
calibration period (January 1,
1984 to December 31, 1990). A
second (non-overlapping)
historical period (January 3,
1991 to December 31, 1998) is
designated as the out-of-sample
testing period.
 Step 1: Defining scenarios and time steps
Time (days)
Rate (%)
Historic rates plus lower bound of the 95% envelope for 30-year rate
The test portfolio, held by a
single counterparty, comprises
US denominated at-the-
money fixed-floating swaps
(tenors from one to 10 years),
a swaption and several long-
term caps and floors. These
positions are designed to be
sensitive to very large interest
rate movements.
Calibration
The first “shift” principle
component explains 93% of
the total variance; together,
the first three components
explain 99.9% of the total
variance of the daily log rates.
The target values for the
∞
testing period, y i , are
calculated as the sample
means of the log rates over the
calibration period. The
estimates of annualized mean-
reversion rates for the first
principal components are
0.001, 0.066 and 2.120,
respectively.
Out-of-sample testing
The central 95% inclusion
envelope is defined by the
curves that link the 2.5th and
97.5th percentiles of the
distribution of the interest
rates at each point in time.
The rate lies outside the 30-
year inclusion envelope only
on two short periods. For all
nine rates, the historical data
falls outside the 95% inclusion
envelope for the calibrated
model on 7.7% of days
observed, suggesting that the
scenarios generated by the
model are realistic.
To compare the potential
exposures of the test portfolio
Portfolio Mark-to-Future values
29
based on these scenarios with
the historical exposures realized
in the validation period one
thousand scenario paths over
seven years are generated, with
quarterly time steps in the first
year and semi-annual time steps
thereafter. In each scenario and
at each time step, the MtF value
of each position is computed and
aggregated at the portfolio level.
The maximum 97.5% portfolio
exposure doubles from 10
million USD at the beginning of
the simulation to more than 20
million USD near the end of the
simulation. The estimated
potential exposure of the
portfolio consistently dominates
its actual exposure. However, in
the short term, the value of the
portfolio is slightly outside of the
95% envelope.
Note that the out-of-sample
testing period covers a dramatic
fall in interest rates between
1991 and 1992 and a dramatic
increase in rates between 1994
and 1995. In spite of this, these
results offer evidence that the
model generates realistic
estimates of worst case
exposures.
30 Step 1: Defining scenarios and time steps

A Model to Generate Electricity Price Scenarios

The electricity market is
characterized by constraints
on the supply side and
pronounced cyclical and
seasonal patterns on the
demand side. Yet demand for
electricity, while highly
variable, is relatively inelastic:
it responds very slowly, if at
all, to even large price
increases.
Quick adjustments in the
supply of electricity are
prevented by the long lead
time required to start up and
shut down some types of
generating equipment. Nor
can electricity be stored for
later use.
volatile, that show sudden,
short-lived large jumps—
particularly in the summer
months—and that exhibit
seasonality and a very strong
mean-reverting behaviour.
Further, the volatility itself can
vary—from being moderately
high at lower price levels to
extremely high at higher price
levels. The volatility is more
evident in the logarithm of daily
spot prices.
A model for spot pricing of
electricity
Scenarios of electricity spot
prices are generated by
specifying a process affecting
change in electricity spot prices
and manipulating it over time.

The dependence on
transmission lines to convey
electricity further limits the
available supply of electricity
between regions. One region
can transfer electricity to
another region with which it is
connected, but an excess of
electricity cannot be rerouted Daily electricity spot prices, February 6, 1997–June 9, 1999
along lines that are already
working at capacity.
Therefore, electricity markets
are regional.

An imbalance of supply and

demand within connected
regions results in spot price
differentials between regions.
The differentials can vary
depending on the day of the
week and the time of day, as
well as on the season and the
weather.

All of these characteristics of

the electricity market result in Logarithm of daily electricity spot prices, February 6, 1997–June 9, 1999
spot prices that are highly
Step 1: Defining scenarios and time steps 31

Let S t denote the spot price of

electricity at time t. The process
that governs the change in the
logarithm of the spot price over a
small time interval d t is

∆ ( ln ( St ) ) = b ( t, St ) ( ln ( S∞ ) – ln ( S t ) )d t

+ σ ( t, S )∆
t

where S ∞ is the long-term

reversion level for the daily spot
price, b ( t, S t ) is the reversion
rate, W t denotes the Brownian
motion, q t is a Poisson process
with intensity λ ( t, S t ) , σ ( t, S t )
denotes the volatility of Log ( S t )
and J is a positive, real-valued
random variable. The three
right-hand side terms in the
process represent, in order, a
mean-reverting drift component,
a continuous drift component
and a jump component,
respectively.

By making the process

parameters dependent on time
and spot price level, the
observed seasonal effects are
accounted for. Additional
features of the market are
accommodated in the model by
imposing appropriate
constraints, such as reflecting
upward and downward barriers.
Electricy price scenarios

Maximum likelihood estimates

of the process parameters are
obtained and scenarios for spot
prices generated using the model
and the 600 days of daily spot
price data.
Observation of three sample
paths indicates that the
simulation captures the
Three sample paths of the logarithm of daily electricity spot prices distribution of the price jumps
and their observed magnitudes
Step 1: Defining scenarios and time steps 32

reasonably well.
33
considerable ongoing academic research is being
conducted to understand the theoretical
properties of the models and their econometric
estimation in practice. Once they are defined and
calibrated, the implementation of continuous
time models in the MtF framework requires the
discretization of the stochastic partial differential
equations to the desired time steps.
Mixed parametric and non-parametric models
Some scenario generation models retain aspects
of both parametric and non-parametric models.
These models can be viewed as bringing an
explicit model of randomness or model
prediction into historical scenarios or,
alternatively, as bringing some explicit, non-
parametric, historical information into a
parametric model.
For example, Hull and White (1998b) present a
methodology that adjusts historical scenarios by
the conditional volatility of the time series,
computed using exponentially weighted moving
averages or GARCH methods. This method
retains the fat-tail characteristics of the historical
data, while using a better forecast of the volatility
of the time series than that given by the sample
volatility. Another example is the use of density
kernel estimators (Ahn et al. 2000) to describe
the marginal distributions of risk factors.
Sampling from this type of function is equivalent
to sampling from history and then adding a
Gaussian noise of a predefined variance.
Step 1: Defining scenarios and time steps
Summary
Scenarios are the heart of a MtF risk
management strategy because the quality of a risk
management analysis depends on the ability to
generate relevant, forward-looking scenarios that
properly represent the future. Moreover,
seemingly disparate risks, such as market, credit
and liquidity risks, are naturally integrated
through the scenarios used in a risk management
analysis. Finally, integration of various
institutional functions and businesses is also
readily achieved when the players speak the
“same language”; i.e., share the same scenarios.
In this chapter, we have further advanced the
idea that scenarios are the language of risk.
Research in computational finance over the last
decade has created powerful historical and
model-based scenario generation techniques
applicable to risk management. In order for these
techniques to be practical, all current economic
and subjective information must be applied
creatively to generate forward-looking scenarios
consistent with current conditions. In the next
chapters, we show how accurate simulation
produces the values that populate the MtF Cube.
This simulation must account for all the events
that affect the future value of the underlying
instruments and for the dynamic portfolio
strategies that model changes to the positions in
the portfolios.
Step 2: Defining the Basis
Instruments
Portfolios consist of positions in a number of financial products, both exchange-traded
and over-the-counter (OTC). The MtF Cube is the package of MtF tables, each
corresponding to an individual basis instrument. A basis instrument may represent an
actual financial product or a synthetic instrument. As the number of OTC products may
be virtually unlimited, it is often possible to substantially reduce the number of basis
instruments required by representing their MtF values as a function of the MtF values
of the abstract instruments. This chapter discusses the issues surrounding the
selection of basis instruments used to build the MtF Cube.

The MtF Cube consists of a set of N MtF
tables—one for each instrument—generated by
simulating a given basis instrument over
S scenarios and T time steps. Basis instruments
may represent actual financial products such as
stocks and bonds, synthetic instruments such as a
series of zero coupon bonds or, in some cases,
abstract indices such as the inputs to a multi-
factor model.
valuation aids in the selection of basis
instruments.
The MtF value, mijt, of basis instrument i,
(i = 1,…,N) under scenario j at time step t is a
function, f(•), of the levels of specified risk
factors and can be represented as
m ijt = f ( u1jt, u 2jt, u 3jt, …, u Kjt )

The choice of basis instruments to be simulated
in the pre-Cube stage of the MtF framework
depends on the overall business application and
may involve trade-offs between the magnitude of
data storage (the dimensions of the MtF Cube)
and pricing accuracy. Nonetheless, the
dimensions of the MtF Cube can often be
significantly reduced with little or no loss of
pricing accuracy by the judicious choice of basis
instruments.
In most applications, the basis instruments
consist of a mixture of actual products
representing exchange-traded securities (or OTC
securities held in inventory) and synthetic
instruments which may be mapped into a large
volume of OTC securities. An understanding of
how risk factors have an impact on product
where u kjt , ( k = 1, …, K ) is the level of risk
factor k under scenario j at time step t.
When the basis instrument represents a synthetic
instrument or an abstract index, it is often a
function of a single risk factor k, m ijt = f ( u kjt ) . In
this case, the basis instrument itself can be
mapped one-to-one to a risk factor.
The key benefit derived from the use of basis
instruments is the ability to pre-compute most of
the results of the computations required to
calculate portfolio MtF values. The MtF value of
a portfolio containing a single financial product is
determined by a post-processing function, g(•),
applied to the pre-computed MtF values of the
basis instruments. In general, when the financial
product is itself defined as a basis instrument in
34 Step 2: Defining the basis instruments

the MtF Cube, the MtF value of the portfolio is
simply the MtF value of the basis instrument
(and g(•) is simply an identity). In the case when
the financial product is not an instrument
defined in the MtF Cube, the MtF value of the
portfolio is calculated as a function, g(•), of the
MtF values of one or more basis instruments.
As illustrated by the schema in Figure 2.1, a
mapping sequence defines the functional
stock and a forward contract (expiring at time t) on
that stock.
In this mapping sequence, the MtF value of the
stock under a scenario j at time step t is simply that
of the stock basis instrument. The MtF value of the
stock basis instrument is modeled as a simple
realization of the stock risk factor under each
scenario and time step. The MtF value of the
forward contract is a straightforward function of

RISK FACTOR BASIS INSTRUMENT PRODUCT PORTFOLIO

f(•) g(•)

Figure 2.1: Mapping sequence of risk factor through to portfolio

relationship between risk factors, basis the MtF values of two basis instruments: the stock
instruments, financial products and portfolios. and a zero coupon bond.

In order to select the appropriate basis
instruments to be contained in the MtF Cube, a
mapping sequence for each financial product
must be defined. The next sections describe some
of the modeling issues involved in defining the
mapping sequence from risk factor to financial
product. In Step 4, the post-processing functions
g(•) are applied to basis instrument MtF values to
produce portfolio MtF values.
Modeling considerations
The choice of basis instruments depends upon
the mapping sequences that result from the
modeling choices made prior to generating the
MtF Cube. As an example, consider mapping
sequence A, illustrated in Figure 2.2, chosen to
determine MtF values for a non-dividend paying
Consider a second mapping sequence, illustrated in
Figure 2.3. In this case, the stock is valued by a
generic N-factor equity model which determines
the MtF value of the stock as a function of its
factor loadings with respect to the individual equity
factors. For example, one equity factor could be a
market index; others could be industry factors.
Under this sequence, the MtF value of the stock is,
once again, simply that of the stock basis
instrument, but now the MtF value of the basis
instrument is based upon the N-factor equity
model. The difference in modeling between
sequence A and sequence B occurs strictly in the
pre-Cube stage.
Finally, consider a third mapping sequence,
illustrated in Figure 2.4. In this case, the basis

RISK FACTOR BASIS INSTRUMENT FINANCIAL PRODUCT

Stock Price Stock Stock

IR Curve (node t) Zero Bond Forward

Figure 2.2: Mapping sequence A

 Step 2: Defining the basis instruments 35

RISK FACTOR BASIS INSTRUMENT FINANCIAL PRODUCT

Equity Factor 1 Stock Stock

Equity Factor n

IR Curve (node i) Zero Bond Forward

Figure 2.3: Mapping sequence B

instruments defining the MtF Cube are the
abstract equity factors themselves. The MtF
value of the stock must, therefore, be determined
in a secondary post-processing step as a function
of the MtF values of the equity factor basis
instruments.
In this sequence, the MtF value of the stock is
determined as a function of the MtF values of
the N equity-factor basis instruments. Unlike
sequences A and B, sequence C involves a
modeling change in the post-Cube stage as well
as in the pre-Cube stage. In other words, the
post-Cube mapping of basis instruments into
portfolios in sequence C requires the mapping of
basis instruments into individual financial
products in an intermediate step.
The benefit of the intermediate step is that the
MtF Cube in this case need never incorporate
more than the N MtF tables associated with each
of the N basis instruments. This is true because
the MtF values of all stocks are functions of the
MtF values of the same N basis instruments,
regardless of the number of stocks in a portfolio.
While it is interesting to compare alternative
modeling techniques, the choice of mapping
sequence often involves more pragmatic trade-offs.
For example, mapping sequence A may be
preferred when full explanatory power is desired for
future equity distributions (perhaps based upon
historical realizations of stock prices). However,
this approach may prove deficient when newly
issued securities (that possess no price history) are
modeled.
In contrast, mapping sequence C may be preferred
for the purpose of minimizing the dimensions of the
MtF Cube as well as for valuing equities with no
previous price history. However, this approach may
be less appropriate when it is important to consider
the specific risks associated with individual
equities. Note that specific risks can still be
addressed in this particular mapping sequence
through more complex post-processing that
directly incorporates the specific risk of the equity
as an additional input. The modeling of specific
risk is discussed in Step 5.
Mapping sequence B may emerge as the preferred
alternative in this case. Specific risk and newly
issued equities may be addressed easily using this
approach, since each security is simulated uniquely
using the factor model, thereby allowing for the

RISK FACTOR BASIS INSTRUMENT FINANCIAL PRODUCT

Equity Factor 1 Equity Factor 1 Stock

Equity Factor n Equity Factor n

IR Curve (node i) Zero Bond Forward

Figure 2.4: Mapping sequence C

36
Table 2.1: MtF values of all-in stock instrument
t=0
Stock instrument s0
Settlement account 0 c1
All-in instrument s0
straightforward incorporation of specific risk.
The trade-off is that this sequence has
implications for the size of the MtF Cube, which
now must incorporate MtF tables for each
individual equity.
Settlement and reinvestment considerations
The choice of appropriate basis instruments is
also influenced by the consideration of cash flow
settlement and reinvestment over time. In order
to capture the distribution over time of the total
return of a financial product, any cash flow
dispersal must also be incorporated in the pre-
computed MtF Cube. This can only be achieved
by defining an all-in basis instrument that
consists of a standard basis instrument and a
settlement account in which any cash settled by
the basis instrument through time is reinvested.
The all-in instrument captures the total return of
a financial product through time.
As an example, consider a stock that pays
dividends at time steps t = 1 and t = 3. An
appropriate risk/reward assessment of this
security at the time horizon, T = 3, requires the
inclusion of any dividends settled (and
reinvested) prior to that time. An all-in stock
instrument represents a portfolio consisting of
the basis stock instrument along with a
settlement account that captures and reinvests
dividends paid at time steps t = 1 and t = 3.
Table 2.1 summarizes the MtF values of the all-in
stock basis instrument across a given scenario
path over the period [t =0, T = 3]. The MtF
value of the all-in instrument is the sum of the
MtF values of the standard instrument and the
cash account.
As a second example, consider an all-in zero
coupon instrument consisting of a standard zero
Step 2: Defining the basis instruments
t=1 t=2 T=3
s1 s2 s3
c1f1,2 c3+c1f1,2 f2,3
s1+ c1 s2+ c1f1,2 s3+ c3 + c1f1,2 f2,3
coupon bond (with a notional of one and
maturity at t = 2) along with a settlement
account which captures and reinvests the
notional amount paid at the maturity date.
Table 2.2 summarizes the MtF values of the all-in
basis instrument across a given scenario path for
the time horizon, T = 4. The MtF value of the
all-in instrument is the sum of the MtF values of
the standard instrument and the cash account.
Figure 2.5 provides an illustration of MtF values
for a one-unit investment in the all-in zero
coupon instrument maturing at t = 2, simulated
across S = 100 scenario paths over the time
horizon, T = 4.
Figure 2.5: MtF values of all-in t = 2 zero
coupon instrument across scenarios
In comparison, Figure 2.6 and Figure 2.7
illustrate the MtF values simulated across
S = 100 scenarios over the time horizon, T = 4,
of one-unit investments in two additional all-in
zero coupon instruments (with maturities of
t = 0 and t = 4, respectively).
Note that the t = 4 all-in instrument poses only
price risk over the time period 0 ≤ t < 4 , during
which its MtF value is sensitive to interest rate
 Step 2: Defining the basis instruments 37

Table 2.2: MtF values of all-in t = 2 zero coupon instrument

t=0 t=1 t= 2 t=3 T=4

Zero coupon bond d0,2 d1,2 1 0 0

Settlement account 0 0 0 f2,3 f2,3 f3,4

All-in instrument d0,2 d1,2 1 f2,3 f2,3 f3,4

changes. At its t = 4 maturity date, when the

notional is settled, it represents a riskless
position. In contrast, the t = 0 all-in instrument
is riskless at its t = 0 maturity date, but poses
reinvestment risk over the duration of the T = 4
time horizon, since the notional amount is
reinvested. The t = 2 all-in instrument has a
changing risk profile over the T = 4 time
horizon; it possesses price risk over the period
t < 2, is riskless at t = 2 and poses reinvestment
risk over the period 2 < t ≤ 4 .

Figure 2.7: MtF values of a all-in t = 4 zero

coupon instrument across scenarios

Explicitly incorporating the passage of time in a

Figure 2.6: MtF values of all-in t = 0 zero
coupon instrument across scenarios
simulation creates some modeling challenges.
Path dependency, settlement, reinvestment and
early exercise are all features of product valuation
that can be appropriately addressed in the
generation of the MtF Cube. The above
examples illustrate the significance of considering
the impact of settlement and reinvestment
through time on the modeling of even the
simplest instruments.
38
Step 3: Simulating to Produce
the MtF Cube
The MtF Cube consists of a set of N MtF tables each associated with a given basis
instrument. The cells of a MtF table contain the MtF values of the basis instrument
simulated over S scenarios and T time steps. This chapter discusses the relationship
between the risk factors, scenario paths and pricing functions used to simulate MtF
values.

Risk factors

Scenario generation MtM valuation

S Scenarios

T Time steps N Basis instruments

Risk factor distributions MtF valuation

S Scenarios
ps
ste
ime
N MtF tables T T

Figure 3.1: Generation of the Basis MtF Cube

40
Once the scenarios and time steps have been
defined, the cell content of a MtF table is
generated by a pricing model that is attached to
the applicable basis instrument. A pricing model
represents a string of pricing functions associated
with specified output attributes; pricing functions
produce MtF values as well as other measures
such as MtF deltas and MtF durations. The
simulation of a basis instrument over the defined
scenarios and time steps produces MtF measures
for the specified output attributes that are
functions of the realized risk factor levels.
Step 3: Simulating to produce the MtF Cube
The MtF table associated with basis instrument i,
Mi, is of dimension S x T, where S is the number
of scenarios and T is the number of time steps.
The cells of Mi are populated by simulating the
values of the basis instrument i over each of the
j = 1,…, S scenarios and t = 1, …,T time steps.
The MtF Cube, M, consists of N MtF tables
associated with each of the i = 1,…,N basis
instruments. Figure 3.1 illustrates the process for
generating a Basis MtF Cube.
Step 4: Producing the Portfolio
MtF Table
Key to the MtF framework is the premise that a MtF Cube is generated independently
of portfolio holdings. Any portfolio or portfolio regime (strategy) can be represented by
mapping the MtF Cube into static or dynamically changing portfolio holdings. The
regimes may be predetermined, such as a buy-and-hold strategy, or they may be
conditional upon the scenario-based MtF values, such as a delta-hedging strategy.
Conditional regimes are used to capture liquidity risk. This chapter discusses how
multiple portfolio MtF tables are produced from a single MtF Cube.

In Step 4 of the MtF framework, the MtF Cube is
mapped into multiple portfolios or portfolio
regimes over time. The result of this mapping is
the creation of a portfolio MtF table containing
the MtF values of a portfolio regime simulated
across scenarios and time steps. The mapping
incorporates the holdings in the instruments,
which may be dynamic across scenarios and
through time. Thus, a portfolio MtF table
captures the MtF values of a portfolio regime—
such as a roll-over strategy or an immunization
strategy—in a manner similar to that used to
capture the MtF values of a static portfolio. This
mapping is completely independent of the
generation of the MtF Cube and occurs strictly as
a post-processing step in the post-Cube stage.
A portfolio MtF table, MR, associated with
portfolio regime R has dimensions S x T, where S
is the number of scenarios and T is the number of
time steps. Each cell in the table contains the
MtF value, m jtR , of portfolio regime R under
scenario j at time step t. A value in the portfolio
MtF table is a function g(•) of the values in the
instrument MtF tables contained in the MtF
Cube. In the case where actual financial products
are contained in the MtF Cube, the values in the
portfolio MtF table are a linear combination of
the values in the instrument MtF tables,
weighted by portfolio holdings in each scenario
and time step. In this case, the portfolio MtF
value in scenario j and time step t is
N
R R
m jt = ∑ x ijt ⋅ m ijt
i=1
where x Rijt is the holdings of instrument i under
portfolio regime R for scenario j at time step t.
The positions, x Rijt , are only constant for all
scenarios and time steps for a static buy-and-hold
portfolio regime. In the general case, position size
may be time and scenario dependent, thus
enabling the risk/reward assessment of
dynamically changing portfolios. The fourth step
of the MtF framework maps basis instruments
into the portfolio regimes, as illustrated by the
mapping sequence in Figure 4.1. For now, we
assume the basis instruments are actual financial
products.
42
FINANCIAL PRODUCTS
Figure 4.1: Portfolio mapping sequence
It is useful to identify two general types of
strategies for mapping the MtF Cube into
portfolio holdings: predetermined regimes and
conditional regimes.
Predetermined regimes
In a predetermined regime, portfolio strategies
are independent of the contents of the
MtF Cube, but may, nonetheless, change over
time in a predetermined fashion. Under these
regimes, the values in a portfolio MtF table a
straightforward linear combination of fixed
quantities of the values of financial products. A
static buy-and-hold strategy is simply a special
case of a predetermined regime describing a
schedule of portfolio holdings that remains
constant for all scenarios and time steps.
As a slightly more complex example, consider the
modeling of liquidity risk. In a standard
approach, the change in mark-to-market value—
a portfolio’s unrealized profit and loss—serves as
a proxy for its realized profit and loss or the
actual liquidation of portfolio holdings. A
liquidity-adjusted risk measure is often estimated
by applying an ad hoc addition to a non-adjusted
risk measure. The liquidity risk measure assessed
in a standard risk framework does not
incorporate the explicit passage of time nor allow
for dynamically changing portfolio holdings. In
contrast, the MtF framework allows for the
explicit liquidation of holdings through the
specification of a regime that liquidates the
portfolio over a given time horizon.
FINANCIAL PRODUCTS MAPPING
Bond
Figure 4.2: Mapping of a bond into a portfolio liquidation strategy
Step 4: Producing the portfolio MtF table
PORTFOLIO REGIMES
For example, consider a position in a single bond.
Differing portfolio liquidation assumptions can
be assessed by the application of different
predetermined portfolio regimes. The portfolio
mapping sequence associated with two bond
liquidation regimes is illustrated in Figure 4.2.
First, assume that the given bond position may be
fully liquidated in a single day. In this case, the
distribution of portfolio MtF values over the first
time step represents the one-day market risk of
the bond position, assuming complete liquidation
on that date. A predetermined portfolio regime
captures this liquidation strategy through a
schedule that reduces the holdings in the bond
from 100% to 0% in one day.
Next, assume that the bond position must be
liquidated proportionately over a 10-day time
horizon. The effect of illiquidity is to lock in
exposure to market risk until the position is
closed. A full 10-day distribution of MtF values
must be considered in order to capture this
impact. A predetermined portfolio regime
captures this liquidation strategy through a
schedule that reduces the holdings in the bond at
a rate of 10% each day for 10 days (see page 43).
Note that by dynamically mapping the individual
bonds into appropriate liquidation regimes for a
common 10-day time horizon, the risk of both
liquid and illiquid bonds may now be assessed
within a consistent framework.
A liquidation risk measure must often account
for the reinvestment of any cash settlement in
PORTFOLIO STRATEGY
Liquidation (liquid)
Liquidation (illiquid)
 Step 4: Producing the portfolio MtF table 43

Bond Liquidation Regimes

Consider a single bond (i = 1) A A
m jt = x 1jt ⋅ m 1jt
B B
m jt = x 1jt ⋅ m 1jt
with a MtF value of m1jt.
Under portfolio regime A, the B
= 0 ⋅ m1jt = ( 1 – 0.25 ⋅ t ) ⋅ x 1j0 ⋅ m 1jt
bond is assumed to be liquid; it
can be 100% liquidated by = 0
t = 1. In this case, the for 0 ≤ t ≤ 4
portfolio MtF value at t < 1 is for t ≥ 1
simply and after full liquidation at t > 4
Under portfolio regime B, the B B
A A
m j0 = x 1jt ⋅ m 1jt m jt = x 1jt ⋅ m 1jt
bond is assumed to be illiquid;
it can only be liquidated by
= 1 ⋅ m 1jt = 0 ⋅ m 1jt
25% over each time step
= m 1jt (t = 1,…,4). In this case, the
= 0
portfolio MtF value from
for t < 1 0 ≤ t ≤ 4 can be represented as
for t > 4

and after full liquidation at

t≥1

Regime A MtF
Instrument MtF 100% mA14, ….…, mAS4
liquid regime
100% mA12, ….…, mAS2
t=4 m114, …….…, m1S4 A A
0% m 10, ….…, m S0
t=2 m112, …….…, m1S2
t=0 m110, …….…, m1S0
Regime B MtF
scenarios
100% mB14, ….…, mBS4
illiquid regime 50% mB12, ….…, mBS2
B B
0% m 10, ….…, m S0

Liquidation regimes
44 Step 4: Producing the portfolio MtF table

Equity Liquidation Regimes—Gold Fields

It is May 3, 1999. The trend in
the Gold Fields share price has
been downward over the last
two years. What is the Value-
at-Risk of a position of
300,000 shares of Gold Fields,
the second largest gold
producer in South Africa?
Standard Value-at-Risk
analysis at a 95% confidence
level indicates a probable loss
of 5%, assuming that the
entire position can be
liquidated in the next
24 hours. Given that the Gold Fields: daily volume
average daily trading volume
of Gold Fields on the
Johannesburg Stock Exchange varying degrees of liquidity are 2. High Volatility Scenario
is only 175,000 shares, matched with different Set: In general, as market
portfolio Value-at-Risk is position liquidation regimes to volatility increases, liquidity
increased due to reduced produce realistic estimates of evaporates. Five scenarios at
liquidity—but by how much? the position risk. multiple time horizons are
generated based on the
A Mark-to-Future model 1. Market Risk Scenario trading volumes in the five
Set: First, a set of 100 one- most volatile periods in Gold
Scenarios on Gold Fields’ day shock scenarios that Fields’ share price history.
market price and daily trading take no account of the
volume describe the dynamic impact of liquidity are 3. Low Trading Volume
nature of liquidity risk. Three generated. Scenario Set: The impact of
sets of scenarios applicable to extremely low trading
volumes is captured by
bootstrapping 10 scenarios
at multiple time horizons
based on the 250 lowest
trading volumes from Gold
Fields’ recent history.

The liquidation strategies

The cost of liquidity and the
time to liquidate are modeled by
liquidation strategies. A strategy
describes how the position is
unwound with proceeds from the
disposition settled into cash.

The fall of Gold Fields (Share price = 100 on April 14, 1997)
 Step 4: Producing the portfolio MtF table 45

Simulation Category Scenario Liquidation Strategy

Infinite Market risk only. No impact on liquidity Market Risk Scenario Instantaneous
Liquidity risk. Liquidation

Average Market risk with a reasonable amount of Market Risk Scenario Unconditional
Liquidity liquidity in the market. Liquidation

Limited Market risk with reduced liquidity, Market Risk Scenario Conditional
Liquidity simulating the impact of liquidity under and Liquidation
volatile markets. High Volatility Scenario

Negligible Market risk under the worst case Market Risk Scenario Conditional
Liquidity liquidity scenarios, simulating the impact and Liquidation
of liquidity under extreme situations. Low Trading Volume
Scenario

Scenarios and liquidation strategies

1. Instantaneous The model at work unchanged since the market risk

Liquidation: This strategy
assumes that infinite
liquidity exists in the
market. All 300,000
shares of Gold Fields are
liquidated at the quoted
market price in one day.
2. Unconditional
Liquidation: 10% of the
Gold Fields’ shares are
sold each day over the
next 10 days at the quoted
market price.
When the liquidation
strategies are applied and the
portfolio is Marked-to-Future,
each level of liquidity yields
significantly different results.
As liquidity is reduced, the
liquidation period lengthens
and the portfolio Value-at-
Risk, as a percentage of
portfolio value, increases.
Market risk remains
scenario does not capture
liquidity risk.
How much risk can be
attributable to liquidity and how
long would it take to liquidate
the entire position? By graphing
the liquidity-adjusted results
over time, a liquidation time
horizon can be inferred for a
particular Value-at-Risk or vice
versa.

3. Conditional Liquidation:
Sale of Gold Fields is
restricted to 20% of each
day's trading volume,
assuming that, at this rate,
shares can be sold at the
quoted market price.

Matching scenarios and

strategies
Scenarios and liquidation
strategies are specified for each
of the four liquidity categories:
infinite, average, limited and
negligible (low) liquidity.
Liquidity-adjusted Value-at-Risk
46
FINANCIAL PRODUCTS
Product 1
Product n
Figure 4.3: Mapping of products for an attribution analysis
addition to the bond liquidation mechanism just
described. As the settlement amount depends
upon the bond MtF values under each scenario
and time step, this represents an example of a
conditional regime; conditional regimes are
described in the next section.
As a second example of a predetermined regime,
consider an attribution analysis for a portfolio
over a given time period (see page 47). Standard
risk/reward frameworks presume that the
portfolio holdings do not change; the impact on
the portfolio profit and loss due to market risk
factor changes over this period is captured
through the appropriate selection of scenarios for
the market risk factor levels of the current and
previous periods. In addition to these factors,
however, in the MtF framework, the profit and
loss impact due to time decay can be captured by
explicitly incorporating the passage of time and
the impact due to position change by applying
different portfolio regimes. The portfolio
mapping sequence associated with an attribution
analysis is illustrated in Figure 4.3.
Conditional regimes
In a conditional regime the portfolio strategies
are dependent on the contents of the MtF Cube,
M, or values that may be derived from the MtF
Cube. Under these regimes, the quantity of
holdings is a function of the MtF values for given
scenarios and time steps. The portfolio holding,
R regime applied to a portfolio consisting of an
of instrument i under regime R for scenario j
x ijt ,
at time step t is defined by the function
R
xijt = g ( M )
= g ( f ( u 1jt, u 2jt, u 3jt, …, u Kjt ) )
Step 4: Producing the portfolio MtF table
MAPPING PORTFOLIO STRATEGY
Previous Day holdings
Current Holdings
where g(•) represents a function that maps the
contents of the MtF Cube into the portfolio
holdings appropriate for each scenario and time
step. Notice that portfolio holdings are a function
of the MtF values contained in the MtF Cube
which, in turn, are a deterministic function of the
risk factor levels realized under each scenario and
time step.
As an example, consider a straightforward
Treasury bill roll-over strategy. At the maturity of
a Treasury bill currently held in a portfolio, the
proceeds from its notional amount are reinvested
in a second Treasury bill. The actual quantity of
the second Treasury bill purchased is a function
of its MtF value at the maturity date of the
current Treasury bill. At the maturity of the
second Treasury bill, the proceeds are reinvested
into a third Treasury bill in an amount that is a
function of its MtF value at that second maturity
date. The portfolio mapping sequence is
illustrated in Figure 4.4.
Each scenario path through time dictates a
different total return for the roll-over strategy as
differing quantities of each Treasury bill will be
purchased (see page 48).
As a second example, consider a delta-hedging
equity option, the underlying stock and a cash
account. At specified dates, the portfolio is
dynamically rebalanced to delta hedge the
option. This is achieved by acquiring holdings in
the stock (funded by the cash account) sufficient
 Step 4: Producing the portfolio MtF table 47

Attribution Analysis
Consider the impact of risk
factor and position changes Portfolio
Attribution factor Portfolio MtF value
between the previous day regime
(t = 0) and today (t = 1) on a
Previous day mark-to- A A A
portfolio containing a single m 00 = x 1 ⋅ m 100
market
financial product (i = 1) with
MtF values of m1jt. Change due to market A A A
m 10 = x 1 ⋅ m 110
factors
In addition to capturing the
Change due to time A A A
impact on profit and loss due m 01 = x 1 ⋅ m 101
decay
to market risk factors, the MtF
framework enables the capture Change due to B B B
m 00 = x 1 ⋅ m 100
position change
of the impact on profit and
loss due to time decay and Total profit and loss B B B
m 11 = x 1 ⋅ m 111
position change. Time decay is attribution
modeled by explicitly
Portfolio MtF values for an attribution analysis
incorporating the passage of
time while position change is
modeled by applying different consists of a static portfolio position change are appropriate
portfolio regimes. In this based strictly on the previous for attribution or backtesting
example, two scenarios are day’s positions, or x A1jt = x A1 , for analysis. The impact on profit
utilized: the risk factor levels and loss of the attribution
all j and t. Portfolio regime B
from the previous day (j = 0) analysis is the difference
consists of a static portfolio
and the risk factor levels from between the portfolio MtF
based strictly on today’s
today (j = 1). values under the two regimes
positions, or x B1jt = x B1 , for all j and the portfolio mark-to-
Individual portfolio MtF and t. market value of the previous
values are calculated based on day.
the mapping of two position The mark-to-market value
schedules associated with the from the previous day, as well
change in position from t = 0 as the change in mark-to-
until t = 1. Portfolio regime A market value due to changes
in risk factors, time decay and

Regime A MtF

m A01 mA11
Instrument MtF ions
posit
e rd a y
’s mA00 mA10
Today m101 m111 Yest

Yesterday m100 m110

Tod
a y’s Regime B MtF
p
0 o rs s

osi
j = fac ’s
j = act ay’

1 tors

tion
k ay
k e rd

s m B01 mB11
ris Tod
ris est
f
Y

mB00 mB10
Attribution analysis schema
48 Step 4: Producing the portfolio MtF table

Treasury Bill Roll-over Regime

At the t = 1 maturity of a
current Treasury bill, the
proceeds of notional n are
reinvested in a second
Treasury bill that matures at
t = 3. At the t = 3 maturity of
the second Treasury bill, the
proceeds are reinvested into a
third Treasury bill maturing at
t = 5. While the roll-over
strategy is known at each roll-
over date, the actual holdings
in the three Treasury bills (i =
1, 2, 3) are a function of their
MtF values (m1jt, m2jt, m3jt).
Prior to the first roll-over date
(t < 1), the MtF value of the
portfolio regime can be
represented by the linear
function
R R
m jt = x 1jt ⋅ m1jt function
R R
= 1 ⋅ m 1tj m jt = x 3jt ⋅ m 3jt
= m 1jt
n
2
= -------------------------- ⋅ m 3jt
m 2j1 ⋅ m 3j3
for t < 1
From the first roll-over date for t≥3
(t = 1) until just prior to the
second roll-over date (t < 3), The second equation illustrates
the MtF value of the that at the first reset date (t = 1)
dynamically rebalanced the position in the first Treasury
portfolio can be represented by bill rolls into a second Treasury
the non-linear function bill (with maturity at the next
roll-over date t = 3) in an
R R
m jt = x 2jt ⋅ m2jt amount determined by the MtF
value of the second Treasury bill,
n ⋅m m2j1, under each appropriate
= ---------- 2jt
m 2j1 scenario. The third equation
illustrates that the amount of
for 1 ≤ t < 3
dynamic rebalancing at the next
roll-over date (t = 3) depends
From the second roll-over date
on the MtF value of the third
(t = 3) onward, the MtF value
Treasury bill at that date.
of the portfolio can be
represented as the non-linear

to make the overall portfolio delta neutral. The
portfolio mapping sequence for this portfolio
regime is illustrated in Figure 4.5.
Position holdings change as a function of the MtF
values and the MtF deltas of each product. To
execute a delta-hedging strategy, the MtF Cube
must contain other MtF measures in addition to
MtF values. Specifically, the MtF deltas for each
of the financial products are required. The
impact of delta hedging on the risk and reward
can be captured through a conditional portfolio
regime (see page 50).
Additionally, changes in the MtF values of the
cash account reveal the funding requirements in

FINANCIAL PRODUCTS MAPPING PORTFOLIO STRATEGY

t =1 T-Bill

t =3 T-Bill T-bill Rollover

t =5 T-Bill

Figure 4.4: Mapping Treasury bills into a portfolio roll-over strategy

 Step 4: Producing the portfolio MtF table
FINANCIAL PRODUCTS MAPPING
Equity Option
Equity Underlying
Cash Account
Figure 4.5: Mapping financial products into a portfolio delta-hedging strategy
each scenario, thus determining the associated
funding and liquidity risk. Finally, the
effectiveness of different trading regimes, such as
delta and delta-gamma hedging strategies, can be
easily compared.
A conditional strategy is directly dependent on
the contents of the MtF Cube and, thus, is a
deterministic function of the scenarios that
underlie it. A complex multi-stage, multi-period
stochastic problem has become a single-stage,
multi-period problem that can be readily
analyzed.
Mapping abstract basis instruments into
portfolios
If the full set of financial products of interest is
not contained in the pre-computed MtF Cube,
an intermediate mapping is required to produce
the portfolio MtF values. This intermediate
mapping step determines a MtF value for a given
financial product as a function (linear or non-
linear) of the MtF values of the basis instruments
contained in the MtF Cube. The MtF value of a
portfolio containing this product is then simply a
function of the product MtF value which itself is
a function of the MtF values of the basis
instruments. The mapping sequence in this case
includes the intermediate step, as illustrated in
Figure 4.6.
BASIS INSTRUMENTS PRODUCTS
Figure 4.6: Portfolio mapping sequence with abstract basis
49
PORTFOLIO STRATEGY
Delta Hedging
There are two primary benefits of incorporating
this intermediate step. The first is that all
financial products of interest may not be known
a priori; this step provides a mechanism for
evaluating them in the post-Cube stage rather
than requiring additional simulation in the pre-
Cube stage. The second benefit is that the
judicious choice of basis instruments and
corresponding mapping rules can significantly
reduce the dimensions of the MtF Cube and,
accordingly, the computational requirements in
the pre-Cube stage.
Consider a financial institution with an inventory
of 100,000 vanilla swaps (of a common currency)
and the desire to produce a risk report by
simulating across 1,000 scenarios and over
10 time steps. Without this intermediate
mapping step, the dimensions of the required
MtF Cube are 100,000 instruments x 1,000
scenarios x 10 time steps. The number of cells
contained in the MtF Cube and, hence, the
number of revaluations required is one billion.
The inclusion of an intermediate step that maps
abstract basis instruments into the 100,000 swaps
reduces the computational requirements of this
exercise significantly. If we assume that the swaps
pay cash flows on 5,000 different cash flow dates
(corresponding to daily payments over the next
20 years), then the number of basis instruments
can be reduced to 5,000 without loss of accuracy.
PORTFOLIO REGIMES
50 Step 4: Producing the portfolio MtF table

Delta-Hedging Regime
A delta-hedging regime is
applied to a portfolio
consisting of positions in an
equity option (i = 1), the
underlying equity (i = 2) and
a cash account (i = 3). At
t = 0 the portfolio contains a
single position in the option
and a position in the
underlying equity such that
the overall portfolio is initially
delta neutral. The cash
account at t = 0 has a position
of zero. Under this conditional
delta-hedging regime, at t = 2
and t = 4 the portfolio is
dynamically rebalanced to
delta hedge the option. This is
achieved by acquiring enough
holdings in the equity (funded
by the cash account) so that
the overall portfolio becomes
delta neutral again.
The MtF deltas for each of the
three financial products are
Prior to the first rebalancing From the second rebalancing
date (t = 2), the MtF value of date (t = 4) onward, the MtF
the portfolio can be value of the dynamically
represented as rebalanced portfolio can be
represented as
R R R
m jt = x 1jt ⋅ m 1jt + x 2jt ⋅ m 2jt
R R R R
mjt = x1jt ⋅ m 1jt + x 2jt ⋅ m 2jt + x 3jt
= m 1jt – ∆ 1j0 ⋅ m2jt
⋅ m 3jt
for t ≤ 2 = m 1jt – ∆ 1j4 ⋅ m 2jt
m 2j2
From the first rebalancing date + ( ( ∆ 1j2 – ∆ 1j0 ) ⋅  ----------
m 
(t = 2) until just prior to the 3j2
second rebalancing date
 m 2j4
(t < 4), the MtF value of the + ( ∆ 1j4 – ∆ 1j2 ) ⋅  ------------ ) ⋅ m3jt
 m 3j4
dynamically rebalanced
portfolio can be represented as for t ≥ 4
R R R R
m jt = x 1jt ⋅ m 1jt + x 2jt ⋅ m 2jt + x 3jt The portfolio MtF values in this
example not only enable the
⋅ m 3jt assessment of a delta-managed
portfolio but, additionally,
= m 1jt – ∆ 1j2 ⋅ m 2jt + ( ∆ 1j2 – ∆ 1j0 )
enable the assessment of funding
m2j2 risk by inspection of the cash
⋅  ---------- ⋅ m 3j2
m  account MtF values.
3j2

defined as ∆ijt, (i = 1, 2, 3). for 2 ≤ t < 4

The dimensions of the MtF Cube are reduced to
5,000 instruments x 1,000 scenarios x 10 time
steps and the number of revaluations is reduced
to 50 million, a decrease in the computational
effort by a factor of 20.
As an example, a series of zero coupon all-in basis
instruments can be mapped into an OTC interest
rate swap. Figure 4.7 illustrates the sequence
used to map the MtF values of these basis
instruments into the MtF value of the swap.

RISK FACTORS BASIS INSTRUMENT MAPPING PRODUCT

IR Curve (node t = 1) t =1 Zero Bond

IR Curve (node t = 2) t =2 Zero Bond Swap

IR Curve (node t = 3) t =3 Zero Bond

Figure 4.7: Mapping zero coupon basis instruments into a swap

 Step 4: Producing the portfolio MtF table
BASIS INSTRUMENTS MAPPING
t = 2 Zero Bond
t = 3 Zero Bond
Figure 4.8: Mapping zero coupon basis instruments into zero bond
The MtF value of the fixed leg of the swap can be
determined by a static linear function of the
values of the zero coupon basis instruments,
while the MtF value of the floating leg can be
determined by a dynamic non-linear function of
the values of the same basis instruments. The
mapping of the basis instruments into the floating
leg changes at each reset date and is a function of
their MtF value under each scenario and time
step. This effect can be captured through a
conditional portfolio regime (see page 52).
If the cash flow dates of the swap do not coincide
with the maturity dates of the basis instruments,
a perfect mapping can be achieved by
incorporating a second component in the
intermediate mapping. The function of this
additional mapping component is roughly
equivalent to the interpolation method used to
value cash flows that fall between two nodes on
an interest rate term structure. The
“interpolation” component of the mapping is
illustrated in Figure 4.8.
51
FINANCIAL PRODUCT
t = t* Zero Bond
Including the interpolation component in the
mapping can further reduce the number of basis
instruments required in the MtF Cube. Consider
the 100,000 swaps described above. Assuming
that the institution utilizes a 10-node term
structure in the pricing of these swaps, then the
number of basis instruments can be reduced to 10
without loss of accuracy. The dimensions of the
new MtF Cube are reduced to 10 instruments x
1,000 scenarios x 10 time steps. Correspondingly,
the number of revaluations is reduced
dramatically to 100,000, a decrease in the
computational effort by a factor of 10,000.
Perfect mapping can still be achieved even if the
swaps pay cash flows that do not fall on the term
structure node points. As all independent
interest rate risk factors are represented as basis
instruments in the MtF Cube, the number of
basis instruments need not exceed the number of
nodes in the term structure (see page 53).
52
Mapping Basis Instruments into a Swap
Consider a portfolio
containing a swap with
maturity at t = 3, notional n,
and a fixed rate, rf,
corresponding to a term of
t = 1. The MtF value of a
portfolio A, containing the
fixed leg of the swap is a linear,
static function of the zero
coupon basis instruments
(i = 1, 2, 3) associated with
time steps t = 1, 2, 3
A
m jt = g ( m1jt , m 2jt , m 3jt )
= r f ⋅ n ⋅ m 1jt + r f ⋅ n ⋅ m 2jt
+ ( 1 + r f ) ⋅ n ⋅ m 3jt
for all scenarios and time
steps.
The floating leg mappings
change at each reset date (in
this example, at t = 1, 2) and
are a function of the MtF
value of the appropriate zero
coupon basis instrument under
each scenario. At time t = –1,
the rate has already been
preset at r –1 .
Prior to the first reset date
Step 4: Producing the portfolio MtF table
(t < 1), the MtF value of a term is the value of the
second portfolio, B, containing remaining swap payments (again
the floating leg can be represented using the fixed
represented using the fixed notional representation). From
notional representation of the the second reset date (t = 2)
swap in a linear function onward, the MtF value of the
portfolio containing the floating
B
m jt = g ( m 1jt, m 2jt , m3jt ) leg can be represented as the
non-linear function
= ( 1 + r –1 ) ⋅ n ⋅ m 1jt
B
m jt = g ( m1jt , m 2jt , m 3jt )
for t < 1
1 – 1 ⋅ n
= r – 1 ⋅ n ⋅ m 1jt +  ----------
m 
From the first reset date 2j1
(t = 1) until just prior to the 1 ⋅n ⋅m
⋅ m 2jt + ----------
second reset date (t < 2), the m 3j2 3jt
MtF value of the portfolio
for t ≥ 2
containing the floating leg can
be represented as the non-
Note that the dynamic mapping
linear function
of the basis instruments into the
B swap floating leg is equivalent to
m jt = g ( m1jt , m 2jt , m3jt )
a strategy of rolling over zero
coupon bonds at each reset date.
1
= r – 1 ⋅ n ⋅ m 1jt + ---------- ⋅ n ⋅ m 2jt
m 2j1
for 1 ≤ t < 2
The first term in this
expression is the value of the
reinvested first coupon
payment at t = 1. The second
 Step 4: Producing the portfolio MtF table
Interpolating Abstract Basis Instruments
Consider two zero coupon
basis instruments, (i = 1 and
i = 2), with maturities of t = 2
and t = 3, respectively, that
must be mapped into a single
zero coupon bond that
matures at 2 < t*< 3.
One possible mapping
function is based on linear
interpolation of a term
structure at the level of the
discount factor. In this case,
the MtF value of a portfolio A
containing the zero coupon
bond is a static linear function
of the basis instruments
A m500 = e
m = g (m , m )
jt 1jt 2jt
 t – t*
3 2
=  --------------- ⋅ m 1jt +  --------------- ⋅ m 2jt
t –t
 3 2
for all scenarios and time
steps.
A second possible mapping
function is based on linear
interpolation of a term
structure at the level of the
continuously compounded
zero rate. In this case, the MtF
value of another portfolio B
containing the zero coupon
bond is a static non-linear
function of the basis
instruments
B
m jt = g (m 1jt , m 2jt)
 t3 – t*   t *
 ---------------  ----
= m1jt  t 3 – t2   t 2
53
for all scenarios and time – 0 r2 ⋅ t 2 – 0r 4 ⋅ t 4
m B00 = 10 ⋅ e + 110 ⋅ e
steps.
Assume the term structure of = 10 ⋅ e
– 0.035 ⋅ 2
+ 110 ⋅ e
– 0.045 ⋅ 4
continuously compounded
interest rates is defined by
= 101.20
three independent nodes
corresponding to terms one,
A set of zero coupon basis
three and five. The rates
instruments associated with the
associated with the
independent nodes of the term
intermediate nodes (t = 2 and
structure have values
t = 4) are determined by
linear interpolation. For – 0 r1 ⋅ t 1 – 0.03 ⋅ 1
m 100 = e = e = 0.9704
example, the rate associated
with term t = 2 is – 0 r3 ⋅ t 3 –0.04 ⋅ 3
m300 = e = e = 0.8869
 t 3 – t 2  t 3 – t2
0r2 =  -------------- ⋅ 0r1 +  -------------- ⋅ 0r 3
t –t3 1 t –t3 1 – 0 r5 ⋅ t 5 –0.05 ⋅ 5
= e = 0.7788
3–2 2–1
=  ----------- ⋅ 0.03 +  ----------- ⋅ 0.04
3–1 3–1 In the first mapping approach,
 t* – t  the term structure is linearly
t –t
 3 2 = 0.035 interpolated at the level of the
discount factor. The value of the
Term structure of interest rates bond can therefore be
determined as a function of the
basis instrument values.
rate ort
term t
(%) In this case, the mapping is
strictly a linear combination of
1 3.0
the basis instruments. The
advantage of a linear function,
2 3.5
which limits the complexity of
3 4.0
the mapping, comes at the
4 4.5 expense of perfect replication;
the bond is mispriced by 0.3%.
5 5.0
In the second mapping
The value mB00 of a four- approach, the term structure is
period bond with notional 100 linearly interpolated at the level
USD and coupons of 10 USD of the continuously compounded
payable every two periods is return. The value of the bond
 t * – t   *
 ---------------2  ----
 t – t   t 
t can be determined as another
⋅ m 2jt  3 2 3
function of the basis instrument
values.
54 Step 4: Producing the portfolio MtF table

( t 3 – t2 ) ( t2 – t 1 ) ( t5 – t 4 ) ( t 4 – t3 )
m B00 = 10 ⋅ ------------------
- ⋅ m 100 + ------------------
- ⋅ m 300 + 110 ⋅ ------------------
- ⋅ m 300 + ------------------
- ⋅ m 500
( t 3 – t1 ) ( t3 – t 1 ) ( t5 – t 3 ) ( t 5 – t3 )

2 – 1 ) ⋅ 0.8869 + 110 ⋅ (----------------

3 – 2 ) ⋅ 0.9704 + (----------------
= 10 ⋅ (---------------- ( 4 – 3 )- ⋅ 0.7788
5 – 4 ) ⋅ 0.8869 + ------------------
(3 – 1 ) (3 – 1 ) (5 – 3 ) ( 5 – 33)

= 100.90

First mapping approach

In this case, the mapping is a basis instruments. This however, perfect replication of
non-linear combination of the mapping is more complex, the bond can be achieved.

(t – t ) t (t – t ) t t –t t t –t t
3 2 ⋅ ----2
-------------------- 2 1 ⋅ ----2
-------------------- 5 4 ⋅ ----4
--------------- 4 3 ⋅ ----
--------------- 4

m B00 = 10 ⋅ m 100 ( t 3 – t 1) t
1 ⋅ m 300 ( t3 – t1 ) t
3 + 110 ⋅ m 300 t5 – t 3 t
3 ⋅ m500t 5 – t3 t
5

( 3 – 2) 2 (2 – 1) 2 (5 – 4) 4 ( 4 – 3) 4
---------------- ⋅ -- ---------------- ⋅ -- ---------------- ⋅ -- ---------------- ⋅ --
( 3 – 1) 1 (3 – 1) 3 (5 – 3) 3 ( 5 – 3) 5
= 10 ⋅ 0.9704 ⋅ 0.8869 + 110 ⋅ 0.8869 ⋅ 07788

= 101.20

Second mapping approach

Step 5: Producing the Desired
Risk/Reward Measures
The portfolio MtF table resulting from the mapping of the MtF Cube into a given
portfolio or portfolio regime contains a full description of future uncertainty. Each cell
of the portfolio MtF table contains a portfolio MtF value for a given scenario and time
step. The actual risk and reward measures chosen to characterize this uncertainty can
be arbitrarily defined and incorporated strictly in the post-Cube stage. In this chapter,
we present a selection of market, credit and liquidity risk measures, as well as reward
and performance measures, that can be calculated in the post-Cube stage.

In Step 5, risk/reward measures as well as other
quantitative portfolio analytics are applied to the
portfolio MtF table. Four general categories of
analytics may be applied to
• calculate distribution descriptors from the
portfolio MtF table
• transform MtF values into other MtF
measures
• trade off risk and reward
• incorporate specific risk.
A key construct underlying the calculation of the
distribution descriptors associated with various
risk/reward measures is that the underlying input
for each is the same MtF Cube. Thus, the MtF
methodology provides a unifying framework for
the integration of market risk, credit risk and
liquidity risk measures. A variety of summary
statistics can be calculated by aggregating the
R
MtF values, m ijt , across the scenario and/or time
step dimensions of a portfolio MtF table. Thus, in
addition to standard measures that may not
account for the passage of time, the MtF
framework incorporates forward-looking
measures based on future distributions of MtF
values. In some cases, additional information,
such as scenario probabilities or counterparty
default probabilities are required. In others, the
MtF values must be transformed into other
measures before being used to calculate risk/
reward measures.
Calculating distribution descriptors
Typical post-processing applications based on
untransformed MtF values calculate statistics
characterizing the market risk and liquidity risk
associated with particular portfolios or portfolio
regimes. Selected measures associated with these
two risk classes are summarized in Table 5.1 and
Table 5.2. In some cases, the applications require
the scenario weightings as defined by the S x 1
probability vector p, where each cell
p j, ( j = 1 , 2, …, S ) contains the probability
associated with each state j. The formulations are
based on the notation summarized in Table N.4
(see page 80.)
The MtF Cube can be used for the assessment of
reward as well as for risk measurement. Table 5.3
provides selected reward measures applied as
post-processing applications.
56 Step 5: Producing the desired risk/reward measures

Table 5.1: Selected market risk measures

Measure Formulation

Variance
S 2
R 2  R  S R 
( σt ) = ∑ j  jt  ∑ j jt 
p  m –  p m  
j=1 j=1

Value-at-Risk R R R
VaR t ( α ): Pr { ( m 0t – m jt ) ≥ VaR Rt ( α ) }
(confidence level
α) = 1–α

Expected shortfall S
(confidence level R 1 R R
E [ S jt ] ( α ) = ------------ ∑ p j ( m 0t – m jt – VaR Rt ( α ) )+
α) 1–α
j=1

Regret (risk- S
preference R R –
λE [ D t ] = λ ∑ p j ( m jt – τ jt )
adjusted expected
j=1
downside)

Put value (value

of downside)  S R –
Put Rt =  ∑ ρ j ( m jt – τjt )  ⋅ m 1jt
j = 1 

Table 5.2: Selected liquidity risk measure

Measure Formulation

Liquidity-adjusted
R  R R t∗ 
VaR (period t*, VaR t, t∗ ( α ): Pr  ( m 0t∗ – m jt ) ≥ VaR Rt ( α ) 
confidence level α)  
= 1–α

A detailed example • a long position on the DAX such that the

Consider a portfolio in which a leveraged
exposure has been taken on the DAX index. The
objective is to describe the risk profile of the
portfolio based on a 30-day time horizon.
The overall position has a mark-to-market value
of 5.0 million EUR and consists of the following
products:
• a cash account of 4.0 million EUR.
• a short “at-the-money” straddle (short
positions in both a call and a put on the
DAX)
overall position is delta neutral.
Figure 5.1 illustrates the values of the overall
position and each of its components simulated
over moves in the DAX ranging from a 10%
decline to a 10% increase; zero represents the
current level of the DAX.
Since the overall position is delta neutral, the
value of the portfolio is relatively insensitive to
local changes in the DAX. As such, a simple
parametric approach to measuring VaR (based on
delta-equivalent exposures) produces a measure
that suggests negligible risk.
 Step 5: Producing the desired risk/reward measures 57

Table 5.3: Selected reward measures

Measure Formulation

Expected profit and loss S

(P&L) R R R
E t∗ [ P&L ] = ∑ pj ( m jt∗ – m0t )
j=1

Expected return S R
R p j m jt∗
R t∗ = ∑ -------------
R
–1
j = 1 m 0t

Expected upside S
R R
E [ Ut ] = ∑ pj( mjt – τ jt )+
j=1

Call value (value of upside)

R  S R 
Call t =  ∑ ρ j ( m jt – τjt ) + ⋅ m 1jt
j = 1 

upward or downward. Therefore, there must be

other enticements for investors who take on this
position that are not captured by changes in the
DAX alone.
A second key factor missing from this analysis, as
illustrated in Figure 5.2, is the fact that the
portfolio has positive drift associated with the
passage of time. The time decay inherent in the
short straddle is such that, if everything else
remains constant, the overall position will gain
value over time.

Figure 5.1: Mark-to-market of the portfolio over

a range of DAX values

A couple of key factors are missing from this

analysis. One, of course, is that this position is
highly non-linear. For small changes in the DAX,
the change in value of the overall position is
minor: a 2.5% DAX move (in either direction)
results in a 1.5% loss. For larger changes in the
DAX, however, the change in the value of the
overall position is dramatic: a 10% DAX move
(in either direction) results in a 40% loss. Clearly,
a simple parametric VaR measure cannot
adequately describe the risk inherent in this Figure 5.2: Positive drift associated with the
position. portfolio

Another observation from Figure 5.1 is that the In addition, the value of the short straddle is
portfolio loses value for all DAX moves, whether highly sensitive to changes in the implied
58 Step 5: Producing the desired risk/reward measures

volatilities associated with the options on the

underlying DAX. As the call and put values are
positively correlated with implied volatilities, a
volatility increase will result in a decrease in the
value of the short straddle and, hence, of the
overall position. In contrast, a decrease in
implied volatilities will result in an increase in
the value of the overall position.

Since a parametric approach to estimating VaR

for this position is completely inadequate,
consider instead a standard Monte Carlo
approach designed to capture the portfolio’s a) P&L by scenario
inherent non-linearity. In this approach, the
value of the position is simulated over
100 scenarios containing instantaneous shocks to
the relevant risk factors.

In Figure 5.3a, the profit and loss of the overall

position, corresponding to 100 Monte Carlo-
generated scenarios on 30-day changes in the
value of the DAX (based on a volatility estimated
from a time series of DAX history), is displayed
along the vertical axis. In Figure 5.3b, post-
processing is applied to produce a histogram of
profit and loss. b) Histogram of P&L

The mean and 95% VaR measures for the 30-day Figure 5.3: Changes in portfolio MtM values
time horizon are calculated to be losses of across Monte Carlo scenarios
1 million EUR and 4.5 million EUR, respectively.
This is not surprising. Inspection of Figure 5.3a
reveals that every scenario results in a loss, and
thus there appears to be risk with no possibility of
reward. A standard Monte Carlo approach
captures the non-linearity but misses the reward
derived from the positive drift that accrues from
the passage of time. In addition, standard Monte
Carlo approaches typically do not account for the
risk associated with changes in implied
volatilities.

Within the MtF framework, the passage of time is

captured explicitly by scenarios that now
represent the evolution of risk factors through
time and not merely instantaneous shocks.
Consider the same position and the same set of
100 scenarios triggered not instantaneously, but
evolving daily over a 30-day time horizon.
Figure 5.4 illustrates the MtF values of the
portfolio simulated daily over the 30-day time
horizon.
Figure 5.4: Portfolio MtF values over 100
scenario paths
Each line represents the value of the position
over a given scenario path through time. The
paths of MtF values over time provide much
greater insights into the dynamics of the position
and, hence, its risk/reward profile.
 Step 5: Producing the desired risk/reward measures 59

Note that the positive drift of the portfolio is
captured as most scenario paths result in a
modest profit. A number of scenario paths,
however, result in a loss that, in contrast, can be
quite dramatic. This is the risk inherent in the
portfolio if the positions are static over the 30-
day time horizon. The mean and 95% VaR
measures in 30 days are calculated to be a gain of
250,000 EUR and a loss of 4.0 million EUR,
respectively. There is a 2.5% chance that the
portfolio will be in ruin, having lost all of its
initial value of 5 million EUR.
With the imposition of the delta-neutral regime,
it is now possible to assess the risks of a managed
portfolio. Under this regime, the mean and 95%
VaR measures in 30 days are calculated to be a
gain of 175,000 EUR and a loss of 750,000 EUR,
respectively. There is a 2.5% chance that the
portfolio will lose 20% of its initial value but no
chance that the portfolio will be in ruin. Analysis
of the managed portfolio reveals that delta
hedging constrains the potential downside risk of
the portfolio considerably, but at the expense of
reduced mean performance.

This analysis can be taken even further if we

The MtF framework allows us to take this
analysis yet further. Suppose that the portfolio
positions are not static but rather that the
portfolio is managed over the 30-day horizon.
Consider a portfolio regime designed to maintain
delta neutrality of the overall position by trading
in the DAX and funding the trades by the cash
account. Figure 5.5 illustrates the MtF values of
the dynamically rebalanced portfolio simulated
daily over the 30-day time horizon.
Figure 5.5: Dynamic MtF values over 100
scenario paths
consider the funding and market liquidity issues
that may arise under each scenario and time step
as quantities of the DAX must be purchased.
Inspection of the changes in the level of the cash
account required to fund the strategy provides a
means for assessing funding risk.
Transforming MtF values
In certain applications, it is necessary to
transform the product or portfolio MtF values
prior to the calculation of risk/reward measures.
The transformation can be any arbitrary function
(linear or non-linear) applied to the portfolio
MtF value.
A function that takes the maximum of the
portfolio MtF value and zero transforms the MtF
value to a MtF measure of counterparty credit
exposure. In addition, if the portfolio is
composed of multiple positions, the
transformation may also account for netting rules
and other applicable migration provisions. Note
that for the measurement of counterparty credit
exposure, there is no need to account for total
return, and therefore no need to model cash flow

Table 5.4: Transformation of MtF values to credit exposure measures

Measure Transformation

Actual exposure R R
AE jt = max [ mjt ,0 ]

Potential exposure R R R
PE jt = maxt < t* ≤ T [ m jt* – AE jt ,0 ]

Total exposure R R R
TE jt = AE jt + PE jt
60
a) MtF values
c) MtF potential exposures
Figure 5.6: Transforming portfolio MtF values
reinvestment through the definition of all-in
instruments.
Table 5.4 summarizes the transformations of
portfolio MtF values required to provide some
example credit exposure measures. Note that
these transformation functions are based solely
on the information residing in the portfolio MtF
table. To calculate actual exposure, a simple
transformation is applied to the portfolio MtF
value under each scenario and time step. In the
slightly more complex case of potential exposure,
the transformation is based on all portfolio MtF
values over the t ≤ t* ≤ T time horizon for a given
scenario.
Figure 5.6a illustrates the portfolio MtF values of
a position with exposure to a given counterparty
across three scenarios and over 10 time steps.
Step 5: Producing the desired risk/reward measures
b) MtF actual exposures
d) MtF total exposures
Figure 5.6b illustrates the transformation of
portfolio MtF values into counterparty MtF
actual exposures across three scenarios and over
10 time steps. Figure 5.6c and Figure 5.6d
illustrate the transformations of portfolio MtF
values into counterparty MtF potential exposures
and MtF total exposures, respectively, across
three scenarios and over 10 time steps.
In other cases, additional information such as
counterparty default probabilities and recovery
rates may be required. This information can be
incorporated statically or dynamically in the
transformation in the algorithms embedded in
the post-processing application. A summary of
selected counterparty credit risk measures is
presented in Table 5.5.
 Step 5: Producing the desired risk/reward measures 61

Table 5.5: Selected credit risk measures

Measure Formulation

Expected S
counterparty R R
credit exposure
E [ TE jt ] = ∑ pjT E jt
j=1

Expected S T
counterparty R R R R
credit loss
Lt = ∑ pj ⋅ ∑ A E jt ∗ ⋅ p ( t∗ j ) ⋅ ( 1 – r ( t∗ j ) )
j=1 t∗ = t

Expected cross-

∑ . ∑ AE
S T R
counterparty R R R
credit loss
Lt = ∑ pj ⋅ jt∗
⋅ p ( t∗ j ) ⋅ ( 1 – r ( t∗ j ) )
j=1 t∗ = t R = 1

Trading off risk and reward S

+
R R

Both risk and reward measures calculated in this

step may span the scenario and time dimensions
of a portfolio MtF table. Such an approach is
ideal for the calculation of measures that are
based upon the relative performance of a
portfolio strategy with respect to a benchmark.
Consider the measure expected downside,
defined as the expected under performance of a
portfolio regime R with respect to the
benchmark’s performance across a range of
scenarios (see Table 5.1). If the functions (a)+
and (a)– equal max(a,0) and min(a,0),
respectively, then the expected downside at time
t for portfolio regime R (with respect to a
benchmark) is equal to
R
S
R –
E [ Dt ] = ∑ pj ( m jt – τjt )
j=1
where τjt represents the value of an arbitrary
benchmark under scenario j at time t. Expected
downside is an ideal measure for evaluating the
performance of mutual funds with respect to
target payoffs. Notice that this measure is
identical to the expected payoff of a put option
on the current value of the portfolio.
E [ Ut ] = ∑ pj ( m jt – τ jt )
j=1
which allows us to define the Put/Call Efficient
Frontier. This frontier can be formulated as
* R R
U t = E [ U t ] – λE [ D t ]
where λ represents a coefficient of risk aversion.
Table 5.6 summarizes selected performance
measures that can be implemented in post-
processing applications.
Incorporating specific risk
Specific risk may be incorporated into an analysis
by simply including the specific risk factors
directly in the original scenarios. Examples of this
approach include modeling individual equities as
unique risk factors (see Figure 2.2 in Step 2) and
including “spreads-over-yields” as risk factors for
individual bonds. The disadvantage of this
approach is that the total number of risk factors
may increase dramatically, implying that the
scenarios required to span the overall risk factor
space may increase in number and complexity.

In addition, regret (risk-preference adjusted In traditional risk management approaches, this

expected downside) can be traded off against the
analogous expected upside measure which is
identical to the expected payoff of a call option
on the current value of the portfolio (see
Table 5.3), or,
issue is often avoided by assuming that enough
diversification exists in the portfolio such that
specific risk is negligible. By adopting this
assumption, specific risk factors may be ignored
completely and excluded from the scenarios.
62
Table 5.6: Selected performance measures
Measure
Sharpe ratio
S t = ------t
RAROC
R *t ( α ) = ----------------------
Put/Call Efficient Frontier
Examples of this approach include modeling
equities by their systemic risk factors alone (see
Figure 2.4 in Step 2) or by holding spreads-over-
yields constant for individual bonds.
The MtF framework offers a powerful alternative
approach. Specific risk may be incorporated in
the post-Cube stage rather than in the pre-Cube
stage by taking advantage of the independence
between systemic risk factors and specific, or
idiosyncratic, risk factors. Given this property,
the specific components of the MtF values of a
set of securities are independent of each other,
conditional upon the occurrence of a given
scenario. This implies that the systemic
component of a MtF value can be pre-computed
and stored in the MtF Cube with the specific risk
component incorporated strictly in the post-
Cube stage, either analytically or through a
secondary sampling exercise. Methodologies that
may be applied in the post-Cube stage include
the law of large numbers, the central limit
theorem, probability generating functions and
moment generating functions.
Step 5: Producing the desired risk/reward measures
Formulation
R
R R
R
σt
R
Rt
-
R
VaR t ( α )
* R R
Ut = E [ U t ] – λE [ D t ]
As an example, for a given equity pricing model,
the specific risk component of an individual
stock is independent of the levels of the systemic
risk factors that, when combined, determine its
MtF value. The pre-computed MtF Cube need
only contain the systemic realizations of
individual stocks under each scenario and time
step. Conditional upon a given scenario, the
specific risk for each stock can be incorporated in
the post-Cube stage to produce appropriate risk/
reward measures combining both systemic and
specific risks.
As a second example, for a given credit risk
model, the specific, or idiosyncratic, component
that contributes to the creditworthiness of a
counterparty is independent of the levels of the
systemic credit drivers. The pre-computed
MtF Cube contains the counterparty MtF credit
exposures as well as the systemic realizations of a
creditworthiness index under each scenario and
time step. Conditional upon a given scenario, the
specific risk component of the creditworthiness
index can be incorporated in the post-Cube
stage. This is further explained in Step 6.
Step 6: Advanced Mark-to-
Future Applications
MtF Cubes may serve as input for applications more complex than calculating simple
risk/reward measures. The properties of linearity and conditional independence on
each scenario can be used to obtain computationally efficient methodologies. For
example, conditional independence within a particular scenario is a powerful tool that
allows the MtF framework to incorporate processes such as joint counterparty
migration effectively. In addition, portfolio or instrument MtF tables may be used as
input to a wide variety of scenario-based risk management and portfolio optimization
applications.

Financial institutions worldwide have devoted
considerable effort to developing enterprise-wide
systems that integrate financial information
across their organizations to measure their
institution’s risk. Probabilistic measures, such as
VaR, are now widely accepted by both financial
institutions and regulators for assigning risk
capital and monitoring risk. Since development
efforts have been driven largely by regulatory and
internal requirements to report risk numbers, the
development of tools to understand and manage
risk across the enterprise has generally lagged
behind those designed to measure it.
Measuring risk is a passive activity; simply
knowing the VaR does not provide much
guidance for managing risk. In contrast, risk
management is a dynamic endeavour, requiring
tools that construct a comprehensive picture that
integrates all types of risk as well as identify and
reduce the sources of risk. Risk management
tools should lead to an effective utilization of the
wealth of financial products available in the
markets to obtain the desired risk and reward
profiles.
The Mark-to-Future framework enables the
integration of various types of risks, such as
market, credit and liquidity risk, and facilitates
the construction of effective scenario-based risk
management and optimization tools. In this
section, we demonstrate these principles with
two applications: an integrated market and credit
risk framework and scenario-based optimization
tools that trade off risk and reward efficiently.
Integrated market and credit risk
Credit risk modeling is one of the most important
topics in risk management and finance today.
The last decade has seen the development of
models for pricing credit risky instruments and
derivatives, for assessing the creditworthiness of
obligors, for managing exposures of derivatives
and for computing portfolio credit losses for
bonds and loan portfolios.
However, common practice still treats market
and credit risk separately. When measuring
market risk, credit risk is commonly not taken
into account; when measuring portfolio credit
risk, the market is assumed to be constant. The
two risks are then “added” in ad hoc ways,
resulting in an incomplete picture of risk.
There are two types of credit risk measurement
models: counterparty credit exposure models and
64
portfolio credit risk models. The integration of
market and credit risk has a major impact in both
cases.
Counterparty exposure models
Derivative desks traditionally manage credit risk
by monitoring and placing limits on counterparty
credit exposures. For derivative portfolios,
counterparty exposure is generally defined as
the economic loss that will be incurred on all
outstanding transactions if a counterparty
defaults, unadjusted for possible future
recoveries. More generally, exposures may also be
defined conditional not only on a counterparty
default but also on a credit migration such as a
downgrade. Counterparty exposure models
measure and aggregate the exposures of all
transactions with a given counterparty.
As explained in Step 5, the total exposure to a
counterparty is defined as a single number which
is the sum of the actual exposure, based on the
mark-to-market of the portfolio, and the
potential exposure, reflecting the changes of the
counterparty exposure in the future. In the BIS
regulatory model, the potential exposure is given
by an add-on factor multiplying the notional of
each transaction (Basle Committee on Banking
Supervision 1988). Although simple to
implement, the model has been widely criticized
because it does not accurately account for the
nature of these exposures in the future. Since
exposures of derivatives such as swaps depend on
the level of the market when default/migration
occurs, models must capture not only the actual
exposure to a counterparty at the time of the
analysis but also its potential future changes.
Recently, more advanced methods based on
Monte Carlo simulation (Aziz and
Charupat 1998) have been implemented by
financial institutions. The contingency of the
market on derivative portfolios and credit risk
can be captured explicitly by using a MtF
framework to simulate counterparty portfolios
through time over a wide range of scenarios.
Furthermore, natural offsets, netting, collateral
and various mitigation techniques used in
practice can be modeled accurately in a MtF
framework. The framework also lends itself to
implementing systematic stress testing for
exposures using techniques such as scenario
banding (Cartolano and Verma 2000).
Step 6: Advanced applications
One of the strongest arguments for integrating
market and credit risk is the desire to avoid
“wrong-way” counterparty exposures. Wrong-way
exposures occur when, in a given scenario, the
market move increases the counterparty
exposure and simultaneously weakens the
counterparty's credit quality. Many analysts have
identified wrong-way exposures as the cause of
US commercial bank problems during the 1998
Asian crisis. Most methodologies do not measure
counterparty exposures properly since they
assume, either explicitly or implicitly, that
interest rates and other financial factors and a
counterparty's credit quality are independent.
Portfolio credit risk models
Counterparty credit risk models focus on risk at
the counterparty level only; they do not attempt
to capture portfolio effects such as the
correlation between counterparty defaults and
migrations. In contrast, portfolio credit risk
models measure credit capital and are specifically
designed to capture portfolio effects, specifically
obligor correlations. Portfolio credit risk models
popular in the industry include CreditMetrics
(J.P. Morgan 1997), CreditRisk+ (Crédit Suisse
Financial Products 1997), Credit Portfolio View
(Wilson 1997a and 1997b) and KMV’s Portfolio
Manager (Kealhofer 1996). Although
superficially they appear quite different—the
models differ in their distributional assumptions,
restrictions, calibration and solution—
Gordy (1998) and Koyluoglu and
Hickman (1998) show an underlying
mathematical equivalence among these models.
Furthermore, empirical work shows generally
that all portfolio credit risk models yield similar
results if the input data is consistent (Crouhy and
Mark 1998, Gordy 1998).
A major limitation of portfolio credit risk models
is the assumption that market risk factors, such
as interest rates, are deterministic. Hence, they
do not account for stochastic exposures. While
this assumption has less consequence for
portfolios of floating rate loans or bonds, it has
great impact on derivatives such as swaps and
options.
Ultimately, a comprehensive framework requires
the full integration of market and credit risk.
 Step 6: Advanced applications
An integrated market and credit risk framework
Iscoe et al. (1999) introduce a multi-step model
based on the MtF framework to measure portfolio
credit risk. The model integrates exposure
simulation and portfolio credit risk methods. By
explicitly modeling stochastic exposures, the
model overcomes the major limitation of current
portfolio models that do not properly account for
the exposure caused by instruments with
embedded derivatives. Furthermore, through the
explicit modeling of default/migration
probabilities conditional on the state of the
economy, the framework also serves as the basis
for estimating accurate wrong-way exposures.
The MtF framework is key to obtaining a
computationally efficient methodology that is
also consistent with the overall risk management
strategy of the institution. First, the methodology
can be seen as a secondary post-processing step
applied to counterparty exposures which are
transformed from the MtF Cube as discussed in
Step 5. This can be the same post-processed
MtF Cube that is used to manage counterparty
credit risk limits. Second, we can exploit the
powerful property of conditional credit
independence also discussed in Step 5 to
minimize the number of scenarios for which
expensive portfolio valuations are calculated.
Thus, advanced Monte Carlo or analytical
techniques that take advantage of the problem
structure can be applied.
Specifically, the model presented in Iscoe et al. is
an improvement over current portfolio models in
three main aspects:
• First, it defines explicitly the joint evolution
of market risk factors and credit drivers
through the realization of scenarios. Market
factors drive the prices of securities and
credit drivers are systemic factors that drive
the creditworthiness of obligors in the
portfolio. Factors are general and can be
microeconomic, macroeconomic, economic
and financial. The MtF values and credit
drivers are stored in the MtF Cube; the MtF
values are transformed to exposures.
• Second, through simulation, it models
stochastic exposures (as do the counterparty
credit exposure models) and conditional
65
default/migration probabilities directly. In
this sense, it constitutes an integration of
counterparty exposure and portfolio credit
risk models and effectively incorporates
wrong-way exposures.
• Finally, it extends the Merton model of
default (1974), as used, for example, in
CreditMetrics, to multiple time steps. It
explicitly solves for multi-step thresholds and
conditional default and migration
probabilities in a general simulation setting.
Figure 6.1 presents a schematic describing the
implementation in the MtF framework of the
five-part approach of Iscoe et al. The framework
consists of five parts:
Part 1: Risk factors and scenarios. Scenarios are
created over the analysis period using a model of
the evolution of the relevant systemic risk
factors. These factors may include both credit
drivers and market factors. The integration of
market and credit risk is achieved in the
scenarios which explicitly define the joint
evolution of market factors and credit drivers.
Part 2: Obligor exposures, recoveries and
losses in a scenario. The amount that will be lost
in the event of default or credit migration, as well
as potential recoveries, is computed under each
scenario. Based on the level of the market factors
in a scenario at each point in time, MtF
exposures for each counterparty are obtained
accounting for netting, mitigation and collateral.
Similarly, recovery rates in the event of default
can be scenario dependent.
Part 3: The joint default/migration model.
Default/migration probabilities vary as a result of
changing economic conditions. An obligor’s
default/migration probabilities are conditioned
on the scenario at each point in time. The
relationship between its conditional probabilities
and the scenario is obtained through an
intermediate variable, called the obligor’s
creditworthiness index (CWI), which represents
the financial health or value of the obligor.
66 Step 6: Advanced applications

Scenarios
Part 1 (risk factors) Basis instruments
Generation of systemic risk factors

Pre-Cube
MtF Cube

Simulation of instrument
MtF values
Mapping into obligors to Obligor mapping into
produce obligor MtF values credit drivers
Obligor MtF Part 3
Part 2 values & CWI’s

Transformation of MtF

Post-Cube
values to exposures

Obligor MtF exposures Conditional probabilities

Estimation of conditional
portfolio loss distributions
Part 4

Portfolio credit loss

Part 5 Estimation of unconditional

portfolio loss distributions

Figure 6.1: Integrated market and credit risk in the MtF framework

Correlations among obligors are determined by
the joint variation of conditional probabilities
across scenarios. Thus, a default/migration model
defines a functional relationship that maps the
CWI and the unconditional default/migration
probabilities into conditional default/migration
probabilities for each scenario and time step.
Default/migration models can be econometric as
in the logit model (Wilson 1997a, 1997b),
structural as in the Merton model (J.P.
Morgan 1997, Iscoe et al. 1999), reduced form or
intensity based (Lando 1997 and 1998, Duffie
and Singleton 1997, Jarrow and Turnbull 2000).
Part 4: Conditional portfolio loss distribution
in a scenario. Conditional upon a scenario,
obligor defaults and migrations are independent.
In practice, the computation of conditional losses
can be onerous. In the most general case, a
Monte Carlo simulation can be applied to
determine conditional portfolio losses. However,
the observation that obligor defaults are
independent permits the application of more
 Step 6: Advanced applications
effective computational tools. Some of these
techniques are described in Crédit Suisse (1997),
Finger (1999) and Nagpal and Bahar (1999).
For example, for very large and homogeneous
portfolios, the law of large numbers can be used
to estimate conditional portfolio losses. As the
number of obligors approaches infinity, the
conditional loss distribution converges to the
mean loss over that scenario; the conditional
variance and higher moments become negligible.
Other methods include the application of the
central limit theorem (which assumes the
number of obligors is large, but not necessarily as
large as that required for the law of large
numbers), the application of moment generating
functions with numerical integration or the
application of probability generating functions
with a discretization of exposures.
Part 5: Aggregation of losses in all scenarios.
Finally, the unconditional distribution of portfolio
credit losses is obtained by averaging the
conditional loss distributions over all possible
scenarios.
In summary, the integration of market and credit
risk is achieved in the scenarios which define
explicitly the joint evolution of market risk
factors and credit drivers. The Mark-to-Future
framework enables the integration of market and
credit risk and an accurate, computationally
efficient estimation of counterparty exposures
and portfolio credit risk.
An example of integrated market and credit
scenarios is presented on page 68.
Risk management tools and optimization
applications
In addition to monitoring risk, an effective risk
management function must help the firm
understand the sources of its exposures, how
market or portfolio changes affect its risk profile
and how to obtain optimal trade-offs between
risk and reward, within and across various
business lines. A comprehensive risk manager’s
framework must
• represent complex portfolios simply
• decompose risk by asset and/or risk factor
67
• explain the effect of new trades on portfolio
risk
• explain the impact of positions in non-linear
instruments and of non-normal risk factor
distributions on portfolio risks
• explain complex, non-intuitive, market views
implicit in the portfolio as well as in the
investment policy or market liquidity
• generate potential hedges and optimize
portfolios.
The most widely used tools are based on
extensions of the insights originally developed by
Markowitz (1952) and Sharpe (1964) in modern
portfolio theory. For example, Litterman (1996a,
1996b, 1997a, 1997b) describes a comprehensive
set of analytical risk management tools,
developed in close collaboration with the late
Fisher Black and his colleagues at Goldman
Sachs. These tools are based on a linear
approximation of the portfolio to measure its risk
and assume a joint (log)normal distribution of
the underlying market risk factors, similar to the
RiskMetrics VaR methodology (Longerstaey and
Zangari 1996). Litterman further emphasized the
dangers of managing risk using only linear
approximations. However, in spite of their
onerous assumptions, the insights provided by
these tools are very powerful and constitute a
solid conceptual basis for a risk management
toolkit. (The reader is also referred to the related
papers by Garman (1996, 1997) on marginal VaR
and risk decomposition.)
Within the Mark-to-Future framework, these
concepts can be extended to create a simulation-
based risk management toolkit. The MtF
simulation-based tools provide additional insights
when the portfolio contains non-linearities, when
the market distributions are not normal or when
there are multiple horizons. Furthermore, they
also explicitly model discrete markets that are
often observed in practice, where trading may be
costly and liquidity limited. The methodology
also naturally accommodates transaction costs,
68
Integrated Market and Credit Risk Scenarios
The integration of market and
credit risk is achieved in
scenarios which explicitly
define the joint evolution of
market risk factors and credit
drivers (Iscoe et al. 1999).
Market factors drive the
prices of securities, and hence
exposures, and credit drivers
are systemic factors that
govern the creditworthiness of
obligors in the portfolio.
Factors are general and can be
microeconomic,
macroeconomic, economic
and financial.
We illustrate the construction
of integrated market and
credit risk scenarios with a
simple example. Consider a
single firm with whom we have
contracted a set of USD
interest rate swaps. The firm is
rated BB. The default
probability term structure for
BB firms in time steps of one
year is described by the
cumulative default
probabilities.
BB cumulative default probabilities
Merton model of default
The financial health of the
firm is driven by the Merton
model of default, in which a
firm defaults when its value
crosses a given boundary. Put
simply, default occurs when
the asset levels of a firm fall
below its liabilities; hence the
firm cannot fulfill its
obligations. The financial
health of the firm is
represented by its
creditworthiness index
(CWI), which may or may not
Step 6: Advanced applications
be observed directly. Default
occurs when the index falls
below a specified boundary,
called the default boundary.
Consider two scenarios of the
firm’s CWI and its default
boundary. In the first scenario,
the firm defaults in three years,
while in the second scenario, the
firm remains solvent since the
scenario does not intersect the
boundary.
We assume that the CWI of the
firm follows a geometric
Brownian motion (GBM). For
simplicity, the process is
standardized to have a unit
standard deviation and zero
mean.
Although the default boundary
in the Merton model cannot be
observed directly, it is possible to
compute it from the default
probability term structure and
the assumption of GBM. The
boundary corresponds to the
boundary for a typical BB firm.
The likelihood that the GBM
process crosses the boundaries
 Step 6: Advanced applications
Ten scenarios on the S&P 500 index
Ten scenarios on the six-month US rate
for the first time by each time
point is represented by the
cumulative probabilities.
Now assume that the
creditworthiness index of the
firm is driven by a single factor
linear model. The S&P 500
index is the systemic credit
driver; the credit driver
explains 5% of the total
variance of the
creditworthiness index.
To measure credit risk, we
construct an integrated
scenario set of the
simultaneous realizations of
the S&P 500 and the interest
rate term structure. The
scenario generation model is
Ten scenarios on conditional default probabilities
69
calibrated to March 3, 2000. We
assume that interest rates follow
a statistical mean-reversion
process, similar, for example, to
the multi-factor model described
on page 28. The mean reversion
speed is 0.1. Target rates are
given by the forward rates. The
S&P 500 credit driver follows a
GBM with instantaneous drift of
–4
5 × 10 and volatility of 1.479.
The instantaneous correlation
between interest rates and the
credit driver is about –14%.
A scenario contains only
systemic information about the
economy. Since the firm’s CWI
also contains an idiosyncratic
component (which accounts for
95% of its variance), it is not
possible to know whether the
firm has defaulted in a given
scenario. However, we can
determine whether its
probabilities of default have
increased or decreased
conditional on the scenario.
For example, the unconditional
likelihood of default of a BB firm
in five years is 9.6%. In scenario
S9 the credit driver decreased
about 1.2 standard deviations in
70
Scenario S9 default probabilities
Ten scenarios on conditional default probabilities
for a second counterparty
Scenario S9 returns
Step 6: Advanced applications
five years. Since the obligor has a
positive correlation to the driver,
the health of the counterparty is
expected to decrease and the
likelihood of default to increase
as the value of the index
decreases. Conditional on
scenario S9, the probability of
default in five years is 11.4%.
In general, conditional
probabilities in a scenario can be
calculated from the combination
of the Merton model and the
multi-factor model of the
creditworthiness index.
Note that the scenarios on the
S&P 500 index, the scenarios on
the six-month rate and the
scenarios on conditional default
probabilities constitute a joint
scenario set in which market and
credit risks are completely
integrated. For example, given
the correlations, when interest
rates increase, the S&P 500 level
is more likely to fall and the
default probabilities are more
likely to increase. This is the
case in scenario S9.
The systemic component of
credit risk captured by the multi-
factor model has a significant
impact on results. Consider the
conditional default probabilities
of a second counterparty for
which the credit driver explains
80% of the variance. For this
counterparty, the five-year
conditional default probability
changes from 11.4% in
scenario S9 to 44.4%.
As can be seen, when the
systemic component of credit
risk is higher, the conditional
default probabilities have higher
volatility.
 Step 6: Advanced applications
liquidity and other specified user constraints, as
well as investor preferences.
MtF risk management tools can be based on risk
measures other than variance; they work well
with risk measures such as VaR, expected
shortfall and regret. In particular, these tools
have proven very useful not only for market risk
analysis, but also for credit risk, for which the
exposure and loss distributions are generally far
from normal (they are skewed and have fat tails),
and for ALM, which requires multi-period
stochastic decision making.
It is widely believed that simulation-based risk
management tools are impractical because they
require substantial additional computational
work (Dowd 1998). In fact, little or no additional
simulation is required to obtain risk management
analytics using efficient computational methods
implemented in the MtF framework.
An extensive literature demonstrates these
points. The basic concepts of MtF-based
optimization applications were first developed in
Dembo (1991), Dembo (1992), Dembo and
King (1992) and Dembo (1995). They were more
recently extended by Dembo (1998a),
Dembo (1998b), Dembo(1998c), Dembo and
Freeman (1998), Dembo and Rosen(1999) and
Dembo and Mausser (2000). These papers show
that using an expected downside risk measure
leads to relevant and linear programming
problems which can be readily solved. Konno and
Yamazaki (1991) also present applications of this
type of risk measure in finance applications.
Rockefellar and Uryasev (2000) demonstrate
that other measures such as conditional VaR
(also known as expected shortfall) are also
tractable and lead to linear programs.
Applications of scenario optimization tools to
credit risk are given in Mausser and
Rosen (1999a, 1999b) and Anderson et
al. (2000). While these efforts have largely
focussed on one-period optimization problems,
there is also a vast literature on multi-stage
stochastic programming applications (see for
example, Carino and Ziemba (1998), Ziemba and
Mulvey (1998) and the references therein).
71
Mausser and Rosen (1998, 1999c) demonstrate
how the MtF framework can be used to create
computationally efficient scenario-based risk
management tools to measure marginal risk, risk
contributions and triangular risk decomposition
and to create trade risk profiles. Dembo and
Rosen (1999) discuss the application of inverse
problems in portfolio replication.
In what follows, we illustrate how these concepts
can be applied to construct optimal portfolios
that trade off risk and reward efficiently.
Portfolio optimization and risk/return efficient
frontiers
Since knowledge of actual product holdings is
not required to generate the MtF Cube, various
risk management tools and portfolio optimization
techniques can be applied in the post-processing
stage. Such methodologies typically involve
constructing a series of portfolios that are
efficient. Efficient portfolios have the highest
reward for a given level of risk, or equivalently,
the lowest risk for a given level of reward. In all
approaches, the key input is a single MtF Cube,
while the specific optimization models are applied
as post-processing applications.
Applications for these models include
• index tracking
• hedging and pricing
• asset allocation
• portfolio compression
• asset-liability management
• risk restructuring
• capital allocation.
The efficient frontier traces the optimal trade-
off between risk and reward. Figure 6.2 illustrates
a typical trade-off profile. By definition, no
portfolio can lie above this frontier. Efficient
portfolios are contained on the frontier.
Portfolio A lies below the frontier and, thus, is
inefficient because alternative portfolios can be
constructed with either a lower level of risk for
the same reward or higher reward for the same
risk.
72
Reward
A unrestricted.
Risk
Figure 6.2: Efficient frontier
Regardless of the particular risk and reward
measures used, a fundamental property of the
risk/reward trade-off is that higher levels of
reward always incur higher levels of risk. In most
cases, the frontier is also concave, implying that
the marginal increase in reward for an additional
unit of risk decreases with the level of risk. Risk/
reward models may be formulated in a dynamic
context (multi-time step) or a static context
(single time step). We focus on the static case.
The Markowitz efficient frontier is produced by
minimizing portfolio variance subject to specified
levels of mean portfolio return. In contrast to a
model that relies solely on a mean-variance
approach, the MtF framework allows much
greater flexibility in defining the risk and reward
dimensions. For example, the Put/Call Efficient
Frontier, produced by maximizing a portfolio’s
expected upside subject to specified levels of
expected downside, can only be formulated in a
MtF framework.
The advantages inherent in optimization
applications for risk/reward assessment in the
MtF framework include
• Risk factor return distributions need not be
normal. In particular, return distributions
may be skewed or have fat tails.
• Underlying risk factor processes may be quite
general and may, for example, incorporate
jumps.
• All instruments including derivatives can be
handled in a consistent fashion.
• Instrument profits and losses can be used,
rather than returns, which enables the
Step 6: Advanced applications
incorporation of instruments with zero cost
(e.g., futures).
• Bid-ask spreads are easily incorporated.
• The choice of risk and reward measures is
• The instruments used in the optimization
need not be actual instruments but may, for
example, represent the values realized by
particular portfolio regimes.
Efficient frontiers are obtained as follows. For a
level of risk k, the portfolio x with the maximum
reward ep(k) is determined by solving the
following optimization problem:
e p ( k ) = Maximize x : Reward
Subject to : Risk < k
x∈X
In this problem, reward and risk may be any of
the measures calculated in Step 5 and the
constraints x ∈ X represent all constraints on x.
Solving this parametric optimization problem for
all levels of k yields the entire efficient frontier.
The actual constraints depend on the particular
optimization model or application. Common
constraints include
• lower and upper bounds on individual
positions
• a maximum portfolio cost
• an upper bound on portfolio under-
performance in any scenario
• group constraints (e.g., no more than a
specified percentage in a given asset class,
lower and upper bounds on portfolio
duration or factor sensitivities).
On page 73, this general concept is applied to
create the Put/Call Efficient Frontier (Dembo
and Mausser 2000).
 Step 6: Advanced applications
The Put/Call Efficient Frontier
In a Mark-to-Future world, a
portfolio can be disaggregated
into its Put Value and Call
Value, corresponding to the
expected amounts by which it
respectively falls below or
exceeds the value of a
benchmark over a given time
horizon, T. The Put/Call
Efficient Frontier (Dembo and
Mausser 2000) identifies the
optimal trade-offs between the
competing objectives of
maximizing a portfolio’s
expected upside (Call Value)
and minimizing its expected
downside (Put Value). As
such, it quantifies a portfolio’s
risk and reward in a simple,
intuitive manner. Given a
utility function, investors can
select the efficient portfolio
that is most desirable with
respect to their individual risk
preferences.
For risk-averse investors, the
relevant Put/Call Efficient
Frontier can be constructed
using linear programming. In
Total cost vs. quantity
addition to being attractive
from a computational
standpoint, this makes it
possible to quantify the costs
of market illiquidity, to find
possible (static) arbitrage
opportunities and to obtain
arbitrage-free prices for new
securities in incomplete
markets.
Let qi be the current price of
security i and denote its Mark-
to-Future value in scenario j
by mijT. Suppose that a one
dollar investment in the
benchmark grows to rj dollars
in scenario j. Then the upside
(u) and downside (d) of a
portfolio containing xi units of
each security i satisfies
T T
u – d = ( M – rq )x
Given a set of scenario
probabilities p, we define the
portfolio’s Call Value to be pTu
and its Put Value to be pTd.
73
Investors are affected by the
finite liquidity of financial
markets; typically, as the size of a
trade increases, for example, so
too does the investor’s per unit
cost. The Put/Call model
accounts for market illiquidity by
decomposing a security into a
series of tranches with
progressively higher costs. The
sizes of the tranches are defined
by their lower and upper bounds,
xL and xU, respectively. The
convexity of the resulting total
cost function ensures that the
tranches are filled in sequence.
The Put/Call Efficient Frontier is
defined by the solutions to
v (k ) = maximize: Call Value
subject to: (1)
Put Value ≤ k
liquidity constraints
for all k ≥ 0. Problem 1
rebalances a portfolio in order to
obtain the largest possible
expected upside while not
incurring more than k units of
expected downside. As k is
increased from zero, the optimal
solution values define the
efficient frontier. Problem 1 can
be formulated as a linear
program:
T
max ( x, u, d ) p u
s.t.
T
p d ≤k
T T
u – d – M – rq  x = 0
 
x ≥ xL
x ≤ xU
u ≥0
d ≥0
74
Selecting an optimal portfolio
The Put/Call Efficient Frontier
is concave and piecewise
linear, and its slope (µ) equals
the marginal Call Value per
unit of Put Value. Intuitively,
µ decreases with increasing k
because the most attractive
opportunities for trading off
Call Value and Put Value are
used up first (i.e., the most
desirable securities attain their
bounds).
Investors having a bi-linear
utility function act in a
manner to maximize
exp ected utility = ( Call value )
– λ ( Put value )
where λ ≥ 0 is the degree of
risk aversion (an investor is
said to be risk-averse if λ > 1).
Given a utility function of this
form, an investor will prefer an
efficient portfolio for which
the Call Value is as large as
possible and the marginal
trade-off between Call Value
and Put Value is at least λ.
Geometrically, this occurs at
the point where a line with
slope λ is tangent to the
efficient frontier.
In practice, there is typically
an upper limit on the amount
of risk that an investor is
prepared to assume. Thus,
investors are effectively
restricted to portfolios on a
truncated efficient frontier
that extends from a Put Value
of zero up to some level ko. An
investor with risk aversion
µ2 < λ < µ1 and tolerance
level ko < kA will select the
portfolio that corresponds to
point B, rather than A, on the
efficient frontier.
Step 6: Advanced applications
The Put/Call model also
provides insights into the prices
of securities, given an investor’s
preferred efficient portfolio. For
example, one can express the
market price of a security as the
sum of an infinite-liquidity price
(i.e., the amount that an
investor is willing to pay for the
security in a perfectly liquid
market) and a corresponding
liquidity adjustment. This
adjustment is positive (i.e., a
premium), negative (i.e., a
discount) or zero, for securities
that are respectively at their
lower bounds, upper bounds or
between their bounds.
Using linear programming
duality theory, one can derive
benchmark-neutral probabilities
ρ that result in an expected gain
of zero, relative to the
benchmark, for all securities at
their infinite-liquidity prices. It
can be shown that the infinite-
liquidity price of a security
equals its expected payoff over ρ,
discounted at the rate ro = rTρ.
This concept of benchmark-
neutral pricing is equivalent to
utility-invariant pricing, which
finds the price qh at which an
investor is indifferent to trading
security h in an optimal
portfolio. Benchmark-neutral
prices exist even when markets
are illiquid and/or incomplete
(although the price does depend
on the risk preferences of the
investor).
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Notation

Table N.1: Indices

Definition Dimension

i instrument index 1xN

j scenario index 1xS

t time step index 1xT

k risk factor index 1xK

Table N.2: Variables and parameters

Definition Elements Dimension

u risk factor values u kjt KxSxT

M Mark-to-Future Cube m ijt NxSxT

Mi Mark-to-Future table for instrument i m ijt SxT

MR Mark-to-Future table for portfolio regime R R SxT

mjt

p statistical scenario probabilities pj 1xS

R holdings in portfolio R R NxSxT

x x ijt

pR(t*) probability of default of counterparty portfolio R at R * 1x S

p ( t j)
*
t≤t ≤T

rR(t*) recovery rate (given default) of counterparty portfolio R at R * 1xS

r ( t j)
*
t≤t ≤T

ρ risk-neutral probability of scenario j ρj 1xS

τ MtF value of a benchmark portfolio under scenario j at τ jt SxT

time t
80 Notation

Table N.3: Functions

Definition

f() function mapping risk factors into MtF values

g() function mapping instrument into MtF values into portfolio MtF values

(a)+ function to determine the maximum of two values, max(a, 0)

(a)– function to determine the minimum of two values, min(a, 0)

Table N.4: Notation for Step 5

s random variable representing stock MtF value st 1xT

c random variable representing cash dividend MtF ct 1xT

value

d random variable representing discount factor d t, t + x 1xT

f random variable representing future value factor f t, t + x 1xT

Table N.5: Coefficients

Definition

α one-sided confidence interval

λ risk aversion coefficient

Algo Research
Quarterly
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In This Issue: Volume 1.1

Measuring Capital Charges for Specific Risk ......................................... 5

We compare specific risk capital charges based on the standardized approach and the
internal models approach. Both approaches are endorsed by the regulators. We find the
internal models approach leads to a lower specific risk capital charge for equity portfolios
and for bonds with shorter maturities and higher credit ratings.

Measuring Portfolio Risk Using Quasi Monte Carlo Methods ................... 17

We consider the application of Quasi Monte Carlo methods to risk measurement. A
scenario generation technique based on low discrepancy Sobol sequences is compared to
one based on pseudo-random number generation. We demonstrate that these methods
significantly improve the performance of the portfolio simulation and, therefore, reduce
the time to obtain reliable risk measurements.

Technology Trends ............................................................................. 27

David Penny, Algorithmics’ Chief Technology Officer, shares his thoughts on Java–what it
is, what promises it fulfills and what challenges lie ahead.

Calculating Credit Exposure and Credit Loss: A Case Study .................... 31

We report a case study of the estimation of credit exposure and credit loss of a sample
portfolio of derivative transactions. The results of an estimation performed using a Monte
Carlo simulation are compared to the amounts of exposure and loss obtained under the
method recommended by the Bank for International Settlements.

Algo Academy Notes .......................................................................... 47

Andrew Aziz discusses an optimization approach to valuation in complete markets that is
based on a fundamental assumption of investor behaviour–that investors prefer more
wealth to less.

RiskLab Corner .................................................................................. 55

A network of financial research labs enables academia and industry to work together to
investigate and develop solutions to critical problems faced by banks, financial
institutions and corporations. RiskLab Corner offers a glimpse of selected RiskLab
research activities.

Contributors ...................................................................................... 59

ALGO RESEARCH QUARTERLY 83 VOL. 1, NO. 1 SEPTEMBER 1998

In This Issue: Volume 1.2

Beyond VaR: From Measuring Risk to Managing Risk ............................ 5

Simulation-based tools for portfolio risk management are developed and applied to
examine the VaR contribution, marginal VaR and trade risk profiles of two example
portfolios.

Principal Component Analysis in Quasi Monte Carlo Simulation ............. 21

We propose a new approach for selecting the appropriate principal components based on
portfolio sensitivities and compare it to a standard approach.

Technology Trends ............................................................................. 31

David Penny, Algorithmics' CTO, discusses the benefits and risks of various software
architecture concepts, from client server, to RPC, to CORBA/DCOM, to Middleware.

Defining Operational Risk ................................................................... 37

Operational risk is considered in the context of the firm and losses are analyzed in terms
of their causes and the events that trigger them. Current definitions are discussed and a
concise definition is proposed.

Dimension Reduction by Asset Blocks ................................................. 43

We estimate portfolio VaR using the covariances of the most significant principal
components by asset blocks, and then stress test both the risk factors and the correlations.

Algo Academy Notes .......................................................................... 59

Andrew Aziz discusses how no-arbitrage pricing approaches are viable even when the total
number of states exceeds the number of independent securities.

RiskLab Corner .................................................................................. 71

A glimpse of selected research activities at the RiskLabs.

Contributors ...................................................................................... 75

ALGO RESEARCH QUARTERLY 84 VOL. 1, NO. 2 DECEMBER 1998

In This Issue: Volume 2.1

Making a Scene... .............................................................................. 5

We capture the Russian ruble crisis in a scenario set and apply it to a portfolio of Brazilian
Brady bonds to develop valuable insights into how market risk may evolve under extreme
conditions.

Credit Risk of an International Bond Portfolio: A Case Study .................. 9

We apply the CreditMetrics methodology to estimate the credit risk of a portfolio of long
dated corporate and sovereign bonds issued in emerging markets. We assess the sensitivity
of the loss distribution to various parameters.

Beyond VaR: Triangular Risk Decomposition ......................................... 31

This paper describes triangular risk decomposition for arbitrary distributions of changes in
value, consistent with the simulation-based approach for calculating the non-parametric
VaR. We examine a portfolio of foreign exchange contracts and discuss the strengths and
limitations of triangular decomposition.

Technology Trends ............................................................................. 45

David Penny, Algorithmics' CTO, discusses the strengths and weaknesses of several
database technologies from simple file systems to OODBs.

Lookback Over the Barrier .................................................................. 51

This paper discusses and prices a new type of option that combines features of both barrier
and lookback options. A static replication technique provides insights into the links
between barrier and lookback options and builds the framework for both static and
dynamic hedging of these options.

Algo Academy Notes .......................................................................... 65

Andrew Aziz discusses the Fundamental Theorem of Asset Pricing as it applies to the
pricing of securities whose value must incorporate the possibility of default and,
accordingly, recovery given default.

RiskLab Corner .................................................................................. 73

A glimpse of selected research activities at the RiskLabs.

Contributors ...................................................................................... 77

ALGO RESEARCH QUARTERLY 85 VOL. 2, NO. 1 MARCH 1999

In This Issue: Volume 2.2

Making a Scene... .............................................................................. 5

We design a stress test using both upside and downside extreme market scenarios and
apply it to Amazon.com to forecast the future of Internet stocks.

Six Rules for Mark-to-Future ............................................................... 11

A Mark-to-Future feature that presents six rules for forward-looking risk measurement.

Mark-to-Future in Practice................................................................... 15
A Mark-to-Future feature that provides a practical example of the six rules.

Applying Scenario Optimization to Portfolio Credit Risk .........................19

Since the distributions of credit losses are typically far from normal, standard techniques
developed for market risk are ineffective for managing credit risk. This paper presents
scenario-based tools that can restructure portfolios to reduce credit risk and optimize the
risk/return trade-off. Optimization models based on regret are particularly effective here.

Technology Trends ............................................................................. 35

David Penny discusses architectural considerations for Mark-to-Future.

Simulation of Fixed-income Portfolios Using Grids ................................ 41

This paper considers the application of low-dimensional grids to the simulation of complex
fixed-income portfolios. The grid simulation methodology is illustrated by a case study of
a callable bond portfolio to demonstrate that grids provide reasonably accurate non-
parametric VaR estimates while substantially reducing the computational time required.

Algo Academy Notes .......................................................................... 51

Andrew Aziz discusses the pricing of credit risky securities in a dynamically completed
market and the resulting relationship between the credit spread of a given term and the
risk-neutral probability of “survival” to that term.

RiskLab Corner .................................................................................. 61

In Print ............................................................................................. 65
Contributors ...................................................................................... 67

ALGO RESEARCH QUARTERLY 86 VOL. 2, NO. 2 JUNE 1999

In This Issue: Volume 2.3

Making a Scene... .............................................................................. 5

Scenario testing is an important component of liquidity risk models. We design a stress
test that extends the standard Value-at-Risk analysis to include the risk associated with
liquidity.

Liability Management Using Dynamic Portfolio Strategies ...................... 9

This paper couples dynamic portfolio strategies with scenario generation in a simulation
methodology to determine how the costs and risks of a liability portfolio evolve over time.
The design of a simplified government debt program is used to illustrate the benefits of
dynamic portfolio strategies.

An Integrated Market and Credit Risk Portfolio Model ........................... 21

We present a multi-step model to measure portfolio credit risk that integrates exposure
simulation and portfolio credit risk techniques. Thus, it overcomes the major limitation
currently shared by portfolio models with derivatives. The model is computationally
efficient because it combines a Mark-to-Future framework of counterparty exposures and
a conditional default probability framework.

Technology Trends ............................................................................. 39

Darek Okarmus uses story format to examine different approaches in data modeling.

A Multi-factor Statistical Model for Interest Rates ................................. 53

A term structure model that produces realistic scenarios of future interest rates is critical
to the effective measurement of counterparty credit exposures. In this paper, we present
a statistical term structure model with mean reversion. A case study is used to explore the
calibration, application and out-of-sample testing of the model in practice.

Algo Academy Notes .......................................................................... 65

Andrew Aziz discusses the relationship between the pricing of credit risky securities and
the capital structure of the firm. Under this class of models, credit risky securities can be
priced with respect to the prices of equity and riskless debt.

RiskLab Corner .................................................................................. 73

Contributors ...................................................................................... 75

ALGO RESEARCH QUARTERLY 87 VOL. 2, NO. 3 SEPTEMBER 1999

In This Issue: Volume 2.4

Making a Scene... .............................................................................. 5

Is the IPO market really as rewarding as it appears? New issues are high risk investments.
Stress testing, using the appropriate forward-looking scenarios, is essential to
understanding the risks and returns of the IPO market.

An Empirical Study of Mark-to-Future for Measuring Risk Intraday .......... 9

The Mark-to-Future (MtF) methodology offers an efficient framework for intraday risk
measurement. A criticism of this methodology is that intraday market movements may
render overnight results obsolete and therefore, irrelevant for intraday decision making.
This criticism is addressed through an empirical study.

Technology Trends ............................................................................. 27

XML is a format for transferring data across the Web. Neil Bartlett discusses the benefits
that can be realized by adopting XML standards in dot-com, STP and component
architecture initiatives in financial services.

Efficient Risk/Return Frontiers for Credit Risk ....................................... 35

We construct efficient frontiers for relevant measures of credit risk and show that
minimum-variance portfolios are markedly inefficient with respect to expected shortfall,
maximum (percentile) losses and unexpected (percentile) losses. Risk measures such as
maximum losses and unexpected losses are intractable in an optimization sense. We use
a simple heuristic procedure to construct an approximate, or empirical, efficient frontier
for a portfolio of emerging markets bonds.

Algo Academy Notes .......................................................................... 49

Andrew Aziz develops a single period valuation framework that models the behaviour of
investors who prefer more to less and are willing to take actions to maximize expected
payoffs for a given level of risk. This behaviour is captured in an optimization model.

RiskLab Corner .................................................................................. 61

Contributors ...................................................................................... 63
The Year in Review ............................................................................ 65

ALGO RESEARCH QUARTERLY 88 VOL. 2, NO. 4 DECEMBER 1999

In This Issue: Volume 3.1

Making a Scene... .............................................................................. 5

John C. Parker investigates whether knowledge of an impending policy announcement by
the Federal Reserve Board is useful in estimating market volatility, and therefore, risk.

The Put/Call Efficient Frontier ............................................................. 13

In a Mark-to-Future world, a portfolio can be disaggregated into its Put Value and Call
Value, corresponding to the expected amounts by which it respectively falls below or
exceeds the value of a specified benchmark over a given time horizon. The Put/Call
Efficient Frontier optimally trades off a portfolio’s expected overperformance and
underperformance of the benchmark.

Using Scenario Banding to Stress Test Counterparty Credit Exposure ....... 27

We explore the use of scenario banding over multiple factors for systematic stress testing
of counterparty credit exposures over a large number of time steps. The results show that
scenario banding is useful for stress testing counterparty credit risk.

Technology Trends ............................................................................. 37

Neil Bartlett observes trends that indicate disk technology is obeying Moore’s Law and
concludes that disk capacity and speed will not constrain the accommodation of emerging
requirements for enterprise-wide risk management.

Applying Portfolio Credit Risk Models to Retail Portfolios ....................... 45

We present a simulation-based model to estimate the credit loss distribution of retail loan
portfolios and apply the model to a sample credit card portfolio of a North American
financial institution. In addition to measuring expected and unexpected losses, we
demonstrate how the model also allows risk to be decomposed into its various sources,
provides an understanding of concentrations and can be used to test how various
economic factors affect portfolio risk.

Algo Academy Notes .......................................................................... 75

Andrew Aziz demonstrates how tight bounds on the equilibrium price of a new security can
be found by incorporating the trade-off between risk and return as revealed by the prices
of securities in the market.

RiskLab Corner .................................................................................. 87

Contributors ...................................................................................... 91

ALGO RESEARCH QUARTERLY 89 VOL. 3, NO. 1 MARCH 2000