Introduction

Today’s challenges
Tomorrow?

New directions in financial mathematics and

risk management

PHAM Xuan Huyên

Université Paris Diderot, and JVN Institute

Workshop: What’s Next for Financial Market in Vietnam:

Derivatives securities
VIASM, Hanoi, July 28-29, 2014

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

Background

80-90’s:

• Quantitative issues were becoming central in finance

growing need for professionals able of understanding maths

• Meanwhile: train mathematicians able to understand finance

Quants: implement, evaluate and use suitable models

I Beginning of new conception of risk

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

Dynamic risk management

• Basic aim: manage and reduce risks as much as possible

• Key argument: dynamic strategies 6= previous techniques

ensuring an average risk through the weighting of different asset
classes. Supported by
increasingly sophisticated mathematical models based on
stochastic calculus

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

Noise risk

• Researchers and practitioners examined not only the models

themselves, but the disruptive factors, the random elements that
distorted curves.

• Markets represented as dynamic systems disturbed by “noise”

I Brownian noise = day-to-day volatility received all the attention

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

Volatility

• Why is volatility important? Because risk management and the

instruments used for it, such that options, depend essentially on
volatility.

• Volatility is an indicator of market “health”, like the temperature

in human body.

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

Noise vs fundamentals

• Sophisticated models with Brownian noise confronted to

observed prices
Difference between the statistical level of noise and that
observed in facts.

• Market participants react to immediate information: noise

create noise

I Underestimate the information based on the historical behavior

of prices:
buy-sell on daily basis, and statistics and historical information
are neglected, and even disappear from models
But these are fundamental!

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

After financial crisis

• Financial crisis (2007-2008) highlighted:

importance of hidden, implicit links of the financial system:
systemic risk

• Until 2008: focus on the “risk of noise”

• Since 2008: risk of chaos

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

Today risk management

• New perception of effective risk management: address better the

complexity of financial systems

• Stronger consideration of collateralization in counterpart risk

Impact on pricing, CVA-DVA

I Financial mathematics are set to undergo an inflection:

collateral management requires to follow several curves at the
same time
integrate multi-curve in interest-rate modeling

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

Systemic risk

• Systemic risk may be defined as the risk that a significant

portion of the financial system fails to function properly.
• The monitoring and management of systemic risk has become a
major issue for regulators and market participants since the 2008
crisis.
• The main difficulty stems from the fact that the industry is used
to manage risks within the specific institution and not as a
coherent and risk-efficient whole:
Contagion effects
Adequate indicators for monitoring systemic risk

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

Various questions

• Mechanisms which lead to systemic risk

• Metrics for systemic risk

• Monitoring and Management of systemic risk

I Need for quantitative and operational answers

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

How to model systemic risk?

Consider an evolving system with a large number of

inter-connected components, each of which can be in a normal
state or in a failed state. One may want to study the probability of
overall failure of the system, that is, its systemic risk.

Examples of effects that contribute to the behavior of systemic

risk:
The intrinsic stability of each component
The strength of external random perturbations to the system
The degree of inter-connectedness or cooperation between
components

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

Mathematical models of systemic risk

Particle systems
Mean-field games
Networks

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

Financial network

Figure: Sample of international financial network

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

Financial networks

• Study the mechanisms and behavior of failure propagation, as

well as distress propagation and disruptions of liquidity

• Network stability of strategic actions of market participants.

Analyze adversarial financial transactions

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

Data structures

• Reduced complexity representations of data generated by large

and complex financial networks

• Develop statistical methods for high-dimensional covariance

estimation in a dynamic context

• Use advances in machine learning and high-dimensional

statistical inference

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

Global view of quantitative risk

• Training should put emphasis on

Statistics
Regulation

• Develop new tools for risk detection:

VaR was suitable to understand what happened if default was
probable but not if default really occured
Reworking on the determination of the exposure to risk

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

Model uncertainty

• Models are structurally imperfect.

At best, they simplify the reality
But a model is wrong by definition.

• Important challenge is to clarify the use that can be made of

them:
Use them while knowing that they are false and, if possible,
understand their limits
Robust risk management of model misspecification

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

Mathematics is of key importance for

• understanding and clarifying models and prices used in

economics and finance

• making heuristic methods mathematically precise

• highlighting model conditions and restrictions on applicability

• working out numerous explicit examples

• leading the way for stress testing and robustness properties

• a relevant mathematical theory on its own!

PHAM Xuan Huyên Financial risk management

 Introduction
Today’s challenges
Tomorrow?

Concluding remarks

• Research driven by
Complexity due to interactions and connectivity
Availability of vast amounts of financial data, and in real time
Need to assess financial risk from a higher, institutional level,
including overall or systemic risk

• During the crisis, much attention was paid to economists,

regulators and policy makers when these are disconnected from the
technological realities (high-frequency trading, new software?)
Danger of creating a regulation completely disconnected from
market reality

I Necessity of a dialogue between the various players and the

different disciplines involved.
PHAM Xuan Huyên Financial risk management