Automatic Numeraire Corrections for Generic Hybrid Simulation

10 Pages Posted: 19 Aug 2013

See all articles by Mark Gibbs

Mark Gibbs

Gibbs Consulting

Russell Goyder

FINCAD Corporation

Date Written: August 16, 2013

Abstract

Modern quantitative finance must address the management of portfolio-level risk, whether computing capital requirements, measuring the cost of counterparty risk (CVA) or its mitigation via collateralization (FVA) or hedging. Such calculations rest on modeling a range of risk factors, across asset classes, in a coherent manner.

This hybrid modeling problem presents considerable challenges, with the result that the state of the art is limited to a few special cases. Coupling between model parameters typically necessitates a bespoke calibration procedure and expensive, short-step Monte Carlo simulation. These issues can be side-stepped if the joint characteristic function is known, but the class of such models is small. In addition, treatment of correlation remains at the level of model parameters, and it seldom relates in a meaningful way to correlations between observable quantities.

We propose a new approach to hybrid modeling based on a careful definition of inter-process correlation, and a new technique, called Automatic Numeraire Corrections. With this approach, an arbitrary collection of models for an arbitrary set of underlyings can be combined at run-time to form a wide variety of hybrid models on-the-fly, in which correlation parameters can be calibrated to observable correlations between physical quantities.

Suggested Citation

Gibbs, Mark and Goyder, Russell, Automatic Numeraire Corrections for Generic Hybrid Simulation (August 16, 2013). Available at SSRN: https://ssrn.com/abstract=2311740 or http://dx.doi.org/10.2139/ssrn.2311740

Mark Gibbs

Gibbs Consulting ( email )

PO Box 244
Cobble Hill, British Columbia V0R 1L0
Canada

HOME PAGE: http://gibbsconsulting.ca

Russell Goyder (Contact Author)

FINCAD Corporation ( email )

Central City, Suite 1750
13450 102nd Ave
Surrey, British Columbia V3T 5X3
Canada

HOME PAGE: http://www.fincad.com

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