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Santa Barbara

Derivatives

of the requirements for the degree of

Doctor of Philosophy

in

by

Douglas W. Vestal

Committee in Charge:

Professor Jean-Pierre Fouque, Chair

Professor Guilluame Bonnet

Professor John Hsu

June 2008

3316500

3316500

2008

The Dissertation of

Douglas W. Vestal is approved:

June 2008

Interacting Particle Systems for Pricing Credit Derivatives

Copyright

c 2008

by

Douglas W. Vestal

iii

To my grandfather, William Addison Vestal,

iv

Acknowledgements

My graduate career has been a journey, both ﬁguratively and literally. Be-

encouragement were critical. First and foremost, I would like to think my ad-

visor Dr. Jean-Pierre Fouque. It was Dr. Fouque’s Financial Mathematics class

with him, and his move to UCSB that has allowed me to experience the won-

derful city of Santa Barbara and of course, wine country. He has provided me

with many opportunities that I know I would not have experienced otherwise. I

years.

I would also like to thank Dr. Guilluame Bonnet and Dr. John Hsu for

dissertation beneﬁted from a special topics class I took with Dr. Bonnet, for

I’d also like to thank our co-author, René Carmona for his feedback and

advice on our research topic. The participants of our NSF FRG research group,

namely Dr. Ronnie Sircar and Dr. Thaleia Zariphopoulou and graduate stu-

dents, provided a wonderful forum for which to present our research and obtain

v

an outside viewpoint. In the Fall of 2007, I had the wonderful opportunity

Hsinchu, Taiwan for one month. This time was extremely valuable for further

exploring my research and my writing. The daily interaction I had with Dr.

Han was extremely beneﬁcial and enlightening. In addition, I’m much appre-

ciative of his family’s hospitality while I was visiting. I’d also like to thank the

for their support and feedback during my week-long stay. I hope to make it

Along my academic career there have been many wonderful teachers and

mathematical sciences. At Apex High School, Mrs. Whitaker and Mr. Trezona

were both ﬁrst-rate instructors and kept me challenged. At N.C. State, I had the

great fortune to take classes with Dr. Paur, Dr. Hartwig, Dr. Bob Martin, and

Dr. Silverstein. Special thanks to Dr. Bob Martin and Dr. Silverstein for their

greatly from the encouragement and conversations with Dr. Silverstein over

I would also like to thank the department of Statistics and Applied Proba-

vi

particular, Dr. Feldman, Dr. Hsu, Dr. Carter, Dr. Bonnet, and staﬀ have been

wonderful.

Along the way I’ve had the great fortune to have a couple of internships. At

Progress Energy, I worked with some wonderful people, namely Yan Gao, John

Daily, Albert Hopping, and Leo Kang. At UBS Investment Bank, Peter Aerni,

Mark Nyfeler, Anders Wulf-Andersen, Oliver Rochet, and Alan Pitts provided

ﬁnancial models.

Thanks also goes to Peter Cotton at Julius Finance who read an early draft

uate career. My brothers, David and Dennis Vestal, and their families, have

provided delightful breaks from the stresses of graduate school. My mother and

stepfather, Marsha and Frank O’Neal, have often provided much needed ﬁnan-

cial and emotional support. I just stumbled upon the ﬁrst budget that they sat

I still use to this day. Thanks also go to my father Randy Vestal who always

Graduate school wouldn’t have been nearly as enjoyable without the creative

outlet of cooking. For this I thank Thomas Keller and his two cookbooks,

vii

The French Laundry Cookbook and Bouchon, which provided the source of

inspiration for never having to eat ramen noodles during graduate school. In

addition, daily walks of our dog Maple to the beach provided welcome relief

during the months I was sequestered at home furiously writing this dissertation.

Last but not least, I couldn’t have done this without the support of my won-

derful wife, Lindsey Vestal. She has been amazingly encouraging and supportive

of me and the diﬀerent twists and turns that accompany graduate school and

ﬁnding a job. In addition, she has been a wonderful editor. She has always

provided the much needed balance and perspective after spending so much time

writing equations. I could not have picked a more wonderful person to share

my life with.

viii

Curriculum Vitæ

Douglas W. Vestal

Education

State University.

versity.

Experience

Selected Publications

D. Vestal, R. Carmona, and J.P. Fouque. Interacting Particle Systems for the

Computation of CDO Tranche Spreads with Rare Defaults. Submitted, Jan.

2008.

SAS

R

OpRisk VaR 2.5 User’s Guide, SAS Publishing, 2004.

ix

Abstract

Interacting Particle Systems for Pricing Credit Derivatives

Douglas W. Vestal

nature of the problem. This fact usually precludes analytical solutions and so

numerical techniques, such as Monte Carlo, are employed. Due to the slow

model that doesn’t lend itself to importance sampling, and the computation

tion to the ﬁeld of credit derivatives pricing under the ﬁrst passage model. Our

x

main result is the derivation of the asymptotic variance of the interacting par-

ticle system for a particular choice of weight function that naturally arises in a

credit derivatives pricing context. We show that the variance of using interact-

ing particle systems for this class of models is substantially less than traditional

computing the variance. We also develop and show how to apply interacting

fall. We also will present several numerical results that conﬁrm our theoretical

results.

xi

Contents

Acknowledgements v

Curriculum Vitæ ix

Abstract x

1 Introduction 1

2.1 Some Common Credit Derivatives . . . . . . . . . . . . . . . . . 9

2.1.1 Defaultable Bond . . . . . . . . . . . . . . . . . . . . . . 9

2.1.2 Credit Default Swap . . . . . . . . . . . . . . . . . . . . 13

2.1.3 Collateralized Debt Obligations . . . . . . . . . . . . . . 15

2.2 Structural-Based Models . . . . . . . . . . . . . . . . . . . . . . 26

2.3 Intensity-Based Models . . . . . . . . . . . . . . . . . . . . . . . 30

2.4 Copula-Based Models . . . . . . . . . . . . . . . . . . . . . . . . 36

3.1 General Class of Feynman-Kac Path Measures . . . . . . . . . . 40

3.2 Useful Results of Feynman-Kac Path Measures . . . . . . . . . . 46

3.2.1 Note on Feynman-Kac Change of Measure . . . . . . . . 48

3.3 Interacting Particle System Interpretation of Feynman-Kac Models 51

3.3.1 Interacting Particle System Algorithm . . . . . . . . . . 55

3.4 Some Convergence Results for Interacting Particle Systems for

Rare Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

xii

4 Credit Derivatives Pricing with Interacting Particle Systems 65

4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

4.2 Problem Formulation . . . . . . . . . . . . . . . . . . . . . . . . 67

4.2.1 Multi-Name Model . . . . . . . . . . . . . . . . . . . . . 70

4.3 Feynman-Kac Path Measures and Interacting Particle Systems . 72

4.3.1 Interacting Particle System Interpretation and General

Algorithm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

4.4 Pricing Using Interacting Particle Systems . . . . . . . . . . . . 78

4.4.1 Note on Choice of Weight Function . . . . . . . . . . . . 80

4.4.2 Algorithm on the Structural Model . . . . . . . . . . . . 82

4.4.3 Note on Algorithm for Pricing Collateralized Debt Obli-

gations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

4.5 Variance Analysis: Single-Name Case . . . . . . . . . . . . . . . 85

5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104

5.2 Single Name . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104

5.3 Multi-Name . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109

6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

6.2 Portfolio Value at Risk . . . . . . . . . . . . . . . . . . . . . . . 113

6.3 Review of Monte Carlo for VaR Calculation . . . . . . . . . . . 115

6.4 Interacting Particle System Interpretation of Value at Risk . . . 117

6.5 Expected Shortfall Calculation . . . . . . . . . . . . . . . . . . . 119

6.5.1 Interacting Particle Systems’ Answer to Expected Short-

fall Contributions . . . . . . . . . . . . . . . . . . . . . . . . . . 121

6.6.1 Further Analysis of Interacting Particle Systems . . . . . 125

6.6.2 Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . 127

6.7 Numerical Example . . . . . . . . . . . . . . . . . . . . . . . . . 128

7 Conclusion 133

A Proofs 135

Bibliography 148

xiii

List of Figures

K = 50, r = .05, σ = .25, η = 0 . . . . . . . . . . . . . . . . . . . . . 30

5.1 Default probabilities for diﬀerent barrier levels for IPS and MC 106

5.2 Variances for diﬀerent barrier levels for IPS and MC . . . . . . . 107

5.3 Standard Deviation to Probability ratio for MC and IPS . . . . 109

5.4 Probability mass function of the loss function described in equa-

tion (6.3) with N = 25 . . . . . . . . . . . . . . . . . . . . . . . . . . 111

5.5 Probability mass function of the loss function described in equa-

tion (6.3) with N = 25 in log scale . . . . . . . . . . . . . . . . . . . 112

6.2 Estimated Expected Shortfall Contributions with Rare Proba-

bilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

xiv

Chapter 1

Introduction

The ﬁeld of option pricing theory can be traced back to the early 1900’s.

Louis Bachelier, often called the father of mathematical ﬁnance, defended his

thesis Théorie de la Spéculation on March 29th, 1900. His thesis started the pro-

of Brownian motion and applying it to option pricing for the French ﬁnancial

markets [8]. Among other things, Bachelier’s thesis postulated two critical in-

gredients that are still used today. The ﬁrst is that asset prices should be valued

under a martingale measure and the second is that the price evolves as a Markov

process.

The past few years have seen an explosive growth in the credit derivatives

market. Meanwhile, the ﬁeld of credit risk and credit derivatives research has

1

Chapter 1. Introduction

plexity, so has the need for fast and accurate numerical methods to accurately

toward Collateralized Debt Obligations (CDOs), under the ﬁrst passage model

where default is a rare event. A CDO is a credit derivative that pools together

many diﬀerent ﬁrms (125 comprises a typical contract) and sells exposure to

diﬀerent default levels of the portfolio; the so-called tranches. This segmentation

of the risk in a portfolio enables the buyer to purchase only the tranches that

they deem appropriate for their hedging positions. Since the tranche levels are

fairly standardized, there are also new products called bespoke CDOs that sell

problem. To accurately price the CDO, the distribution of the joint default for

many names is needed. Even if the distribution of joint defaults is found explic-

itly, there is no guarantee that the expectations that are then needed to compute

tranche spreads can be found analytically. Therefore, the user has to rely on

nature of the problem, PDE-based methods are ruled out and Monte Carlo

(MC) methods are heavily relied upon. While MC methods are easy to imple-

2

Chapter 1. Introduction

addition, due to the rare nature of joint defaults, the computational problem is

exacerbated since many MC simulations are needed to observe the joint default

risk [2, 20]. However, most authors have concentrated on multifactor Gaussian

copula models or the reduced-form model for credit risk. However, we have

not found any reference in the literature that applies importance sampling to

the ﬁrst passage model. In addition, the diﬃculty with implementing impor-

tance sampling is computing the change of measure under which one simulates

the random variables. More information about importance sampling and the

change of measure explicitly. Examples we have in mind are ﬁrst passage models

with stochastic volatility and/or regime switching models with many factors.

niques in path space. That is, we never compute a change of measure explicitly

3

Chapter 1. Introduction

tion/mutation algorithm under the original measure such that the measure in

path space converges to the desired “twisted” measure. This “twisted” measure

will be exactly the change of measure that one would use in an importance

sampling scheme. The advantage is that the random variables are always simu-

lated under the original measure, but through the selection/mutation algorithm

converge to the desired importance sampling measure. Many of the the IPS

techniques and theoretical support we use to design our algorithm can be found

in [11, 12].

complicated model that doesn’t lend itself to importance sampling, and the

ology to use Feynman-Kac path measures and their IPS interpretation to the

ﬁeld of credit derivatives pricing under the ﬁrst passage model. Our main result

is the derivation of the asymptotic variance of the interacting particle system for

pricing context. We show that the variance of using interacting particle systems

for this class of models is substantially less than traditional MC. In addition,

variance. We also develop and show how to apply interacting particle systems

4

Chapter 1. Introduction

troduces the basics of pricing credit derivatives and provides a review of three

separate credit derivatives. The ﬁrst is a defaultable bond, then a credit default

cash ﬂows, the no-arbitrage price of the derivatives are presented in a general

framework without assuming the explicit dynamics of the default times. After

presenting the credit derivatives, we focus our attention on three diﬀerent clas-

sical pricing methods. First we present the structural, or ﬁrst passage model,

as this will be the pricing formulation that is used throughout the dissertation.

We end this chapter by brieﬂy presenting the intensity-based model and the

copula approach.

cle Systems. This chapter leaves ﬁnance behind and introduces the reader to

is analyzed and properties are explored that will be signiﬁcant for developing

5

Chapter 1. Introduction

the results of the dissertation. We then introduce the IPS interpretation of the

Feynman-Kac models and present a general algorithm for changing the mea-

sure in path space. That is, by implementing a selection and mutation scheme

event probabilities.

Systems. This chapter lies at the intersection of the two previous chapters;

we formulate the CDO pricing problem in the structural model under a homo-

the losses the portfolio experiences. We formulate this rare event probability

weight function. We then formulate and compare the theoretical variance of our

IPS estimator to traditional MC. Our main theorem and results are presented

and proved.

presents the numerical results for applying our interacting particle system to

6

Chapter 1. Introduction

pricing CDOs. In addition, we compare the empirical variance between IPS and

ﬁnance. Speciﬁcally, we develop the methodology for using IPS for assessing

for using IPS to compute expected shortfall for a portfolio of credit risky assets.

the dissertation. In addition, we present some topics for future research studies.

7

Chapter 2

Methods

The past few years have seen an explosion in the ﬁeld of credit derivatives.

the ﬁrst six months of 2007, the notional amount underlying credit derivatives

grew from $34.42 trillion to $45.46 trillion; a 32% increase over 2006. This

increase follows on the heels of a 75% increase in 2006 as well. In addition, the

ISDA’s deﬁnition (for the sake of the survey) of credit derivatives only includes

credit default swaps on single names, baskets, and portfolios and as such only

the default risk of their assets. Typically, when discussing the default risk of a

company, one thinks of a company not repaying its loan. Through no arbitrage

8

Chapter 2. Credit Derivatives Pricing Methods

arguments, the price of this risk must be factored into the price of the bonds

issued by the company. That is, the holder of the defaultable instrument must

way to quantify the time of default for a company. While there are many diﬀer-

ent legal deﬁnitions of default, we mention that they can include not repaying

For the remainder of this dissertation, we take the more simple view that default

happens when a company doesn’t repay it’s obligation. While the term obliga-

tion covers defaultable bond payments, it also covers any other asset that the

company owes money on, such as a deep in the money interest rate derivative.

sume that all pricing occurs under a risk-neutral probability measure (Ω, F , P, (Ft )0≤t<∞ )

time.

9

Chapter 2. Credit Derivatives Pricing Methods

Assuming the risk-free interest rate, r, is constant, then the price of a zero-

given by

To price defaultable bonds, one naturally needs to have a model for how a

company defaults. In the Sections 2.2-2.4, we detail some of the diﬀerent ways

in which one can model how a company will default. For the moment, we just

assume that the time of default for a company is given by a stopping time τ .

That is, according to the above deﬁnition, τ is a random time representing the

⎧

⎪

⎪

⎪

⎨1 if τ > T ,

f (T ) =

⎪

⎪

⎪

⎩R if τ ≤ T .

10

Chapter 2. Credit Derivatives Pricing Methods

where R is called the recovery rate. That is, R is the amount that the bond

holder will receive if the company defaults before time T . We assume that R

the event of default, most bond holders can expect to receive some nonzero

from 0 − 40% of the face value of the bond. However, there is a whole separate

literature that deals with modeling the recovery rate as a stochastic process

itself. See [1] for a fairly complete review of the diﬀerent methods for recovery

rate modeling.

11

Chapter 2. Credit Derivatives Pricing Methods

derivatives pricing. The yield spread measures the rate of return, over the ﬁxed

risk-free rate, that the defaultable bond earns. This is interpreted to be the

amount of money that bond holders are compensated for bearing the risk of

default.

Γ̄(t,T )

ln Γ(t,T )

Y (t, T ) = −

T −t

Empirical evidence shows that as the time to maturity decreases, the yield

T →0

While there are many empirical reasons for this fact, Duﬃe and Lando at-

very short maturities, they want to be compensated for the risk of holding the

bond [14].

12

Chapter 2. Credit Derivatives Pricing Methods

The most heavily traded credit derivative is the credit default swap (CDS).

Here we will only consider a single name CDS. Essentially, a single name CDS

allows one party to trade the default risk of holding defaultable bonds to a

second party. That is, party A holds defaultable bonds issued by company

C. A would like to oﬀset some of the risk of holding the defaultable bonds by

party B would pay party A the amount of money that is lost (that is 1 − R

in the set up above). If company C doesn’t default, then party B doesn’t owe

party A anything.

Obviously, party A has to pay party B for this default protection. The

of money that party A pays to party B is called the credit default swap spread.

The goal is to ﬁgure out what the fair price of the CDS spread should be.

While there are many diﬀerent formulations for the payoﬀs for CDS’, for the

ease of exposition and to introduce the ﬂavor of CDS’, we will take a simple

view. The ﬁrst thing to do is to look at the cash payments for both party A

and party B. For simplicity we assume that the notional amount is equal to $1.

13

Chapter 2. Credit Derivatives Pricing Methods

We assume that the two parties have agreed that T1 , . . . , Tn are the payment

dates that party A will pay the spread r to party B. Once default happens,

party A stops paying the spread r . This is called the “premium” payment leg.

For the “protection” leg, party B pays party A the amount LGD = 1 − R

when default happens. At time 0, the value of the payments that party A makes

is

n

VA (r ) = r Γ(0, Ti)1τ >Ti

i=1

Since party B only makes a payment at the default time if it occurs before

n

= LGD Γ(0, τ )1Ti−1 <τ ≤Ti

i=1

Through no arbitrage arguments, the spread r is the value that makes the

above contract fair. That is, we have to solve for r such that

E[VA (r )] = E[VB ]

14

Chapter 2. Credit Derivatives Pricing Methods

n

E[e−rτ 1Ti−1 <τ ≤Ti ]

r = LGD ni=1

If we assume that the protection payment happens the ﬁrst date Ti after

n

Γ(0, Ti )P(Ti−1 < τ ≤ Ti )

r = LGD n

i=1

is given in [13]. In [21], the authors present a two-step procedure for valuing

credit default swaps. The method involves estimating the probability of default

from yields on corporate bonds and then applying those probabilities to value

the CDS by taking an expectation of the cash ﬂows. This paper was extended

The previous section reviewed the basics of CDS’ for single names. The

single name CDS allows a party to transfer the default risk they are exposed

to for a single name. However, often times parties have an exposure to many

diﬀerent names and want to package this risk together. If a company has a

large portfolio comprising of many names, they might not be concerned about

15

Chapter 2. Credit Derivatives Pricing Methods

the individual default of each name, but rather that a small collection of names

protection on each single name in the portfolio. But, if the company could buy

protection on just a slice of the portfolio, then they might be properly hedged

One solution that is becoming more and more popular is the Collateralized

Debt Obligation (CDO). In a CDO, the credit risk associated with a portfolio

of the portfolio amount. Each tranche is characterized by its upper and lower

attachment point. The following table shows a typical structure of a CDO and

its tranches.

Attachment points(%)

Tranche number Tranche name Lower KL Upper KU

1 Equity 0 3

2 Mezzanine 1 3 7

3 Mezzanine 2 7 10

4 Mezzanine 3 10 15

5 Senior 15 30

The rest of this section borrows directly from [15] which provides a very

The protection in the event of a default goes in order of the tranches. That

is, if a total of 6% of the value of the portfolio defaults, then the holder of

16

Chapter 2. Credit Derivatives Pricing Methods

the Equity tranche (0 − 3%) pays the ﬁrst 3% of the losses and the holder of

the ﬁrst Mezzanine tranche (3 − 7%) pays the next 3 to 6% of the losses. The

other tranches are not touched. In this way, the holder of tranche [KL , KU ]

losses exceed KL percent. Therefore, each protection seller is only liable for a

We present a common structure for a CDO. Like a CDS, a CDO has two

payment legs: a ﬁxed leg that the tranche holders receive for selling protection

and a ﬂoating leg the tranche holders pay if the losses hit that tranche. The

ﬁxed leg is known as the tranche spread and is represented by sj for the j

tranche receive payments at a given frequency during the life of the CDO. Once

the tranche that they hold is hit with a loss, they have to pay the amount of

the loss to the protection buyer at the next payment date. The holder of the

tranche stops receiving the protection premium payments once the amount of

that the CDO has payment dates {t1 , . . . , tK } where tK is the maturity and

17

Chapter 2. Credit Derivatives Pricing Methods

addition, suppose that the face value of the assets underlying the CDO at time

t0 = 0 is M.

Let t denote the time that has passed since the CDO was sold. In addition,

we denote by Zt the fraction of losses (of M) that have occurred up until time

t. Therefore, the total loss to the CDO is given by MZt . We denote by Zj,t

the percentage of losses that has struck the j th tranche up until time t. Recall

that the j th tranche is only responsible for losses that exceed KLj percent of the

notional but are less than KUj percent of the notional. In fact, we can write

Zj,t as

Since min(Zt , KUj ) = KUj + min(Zt − KUj , 0), the above equation can be

written as

Therefore, at time t, the amount of loss that the j th tranche has suﬀered is

MZj,t .

Now, if a loss occurs between two payment dates, i.e. tk < t ≤ tk+1 , then at

time tk+1 the holder of the tranches will have to pay the fraction Zj,tk+1 −Zj,tk of

the notional M to the protection buyers. The protection buyer keeps paying the

18

Chapter 2. Credit Derivatives Pricing Methods

spread sj to the protection seller until the j th tranche has suﬀered its maximum

loss.

However, the actual amount of money that the protection buyer pays doesn’t

remain constant because while he/she pays a constant spread sj , the amount

of money that needs protecting is decreasing as losses are suﬀered. That is,

the holder of the tranche receive the periodic payment of sj of the outstanding

its initial amount ((KUj − KLj )M) minus the amount of losses that the tranche

has suﬀered up to time t. That is, representing Φj,t as the amount of notional

19

Chapter 2. Credit Derivatives Pricing Methods

⎧

⎪

⎪

⎪

⎪ (KUj − KLj )M, if Zt < KLj ,

⎪

⎪

⎪

⎪

⎨

= (KUj − Zt )M, if KLj ≤ Zt ≤ KUj .

⎪

⎪

⎪

⎪

⎪

⎪

⎪

⎪

⎩0, if Z > K t Uj

We are now in a position to state exactly what the cash ﬂows will be to each

Recall that the CDO is struck at time t0 = 0 and that {t1 , . . . , tK } are the

agreed upon payment dates. For simplicity we have assumed that η = ti+1 − ti ,

sj ηΦj,t

and

(Zj,t − Zj,t−η )M

over the life of the CDO. However, the net amount they receive changes based

20

Chapter 2. Credit Derivatives Pricing Methods

That is, as the notional amount of losses increases, the eﬀective amount that

protection buyer is paying to protect his/her losses. If some losses have already

occurred, he/she shouldn’t have to pay as much for protection since the amount

that needs protection is lower. This can be seen mathematically by taking the

⎧

⎪

⎪

⎪

⎪

⎪

⎪

0, if Zt < KLj ,

⎪

⎪

∂Φj,t ⎨

= −1, if KL ≤ Zt ≤ KU ,

∂Zt M ⎪

⎪ j j

⎪

⎪

⎪

⎪

⎪

⎪

⎩0, if Zt > KUj ,

CDOs are similar to CDS’ in the sense that neither require an initial invest-

ment and each has two payment legs. CDO’s two payment legs are the ﬁxed

and ﬂoating leg. The ﬁxed leg is given by the spread the tranche holders receive

and the ﬂoating leg is given by the amount of loss protection they have to pay.

The purpose of pricing a CDO is to ﬁnd the tranche spread sj that makes

the CDO fair. That is, we need to ﬁnd the spread sj that makes the discounted

21

Chapter 2. Credit Derivatives Pricing Methods

K

Vf ixed = Γ(0, ti )sj ηE[Φj,ti ]

i=1

K

= Γ(0, ti )sj ηME[(KUj − KLj − Zj,ti )]

i=1

K

= sj ηM Γ(0, ti) E[min(Zti − KLj , 0)] − E[min(Zti − KUj , 0)]

i=1

Again, taking expectations and discounting the cash ﬂows back to time

K

Vf loating = Γ(0, ti )E[(Zj,ti − Zj,ti−1 )M]

i=1

K

= M Γ(0, ti) E[min(Zti − KUj , 0)] − E[min(Zti−1 − KUj , 0)]

i=1

K

+M Γ(0, ti) E[min(Zti−1 − KLj , 0)] − min(Zti − KLj , 0)]

i=1

K

Γ(0, ti ) E[min(Z ti

− K U j

, 0)] − E[min(Z ti−1

− K U j

, 0)]

sj = i=1

K

η i=1 Γ(0, ti ) E[min(Zti − KLj , 0)] − E[min(Zti − KUj , 0)]

K

i=1 Γ(0, ti ) E[min(Z ti−1

− K Lj

, 0)] − E[min(Z ti

− K Lj

, 0)]

+

η Ki=1 Γ(0, t i ) E[min(Z ti − K Lj , 0)] − E[min(Z ti − K Uj , 0)]

22

Chapter 2. Credit Derivatives Pricing Methods

The key component of the above expression is that it relies on being able to

compute

E[min(Zt − Kj , 0)]

for all t ∈ {t1 , . . . , tK } and each of the attachment points Kj . Recall that

So far, we haven’t explicitly described the portfolio underlying the CDO and

as such, haven’t described Zt in much detail. There are many diﬀerent types

of CDOs traded and one way of distinguishing them is by the assets that are

the portfolio. We assume that each of the N names has a default time τi , 1 ≤

i ≤ N. Note that the time of default among the names can and will usually be

correlated.

For simplicity, we assume that each of the individual names underlying the

portfolio are homogeneous. That is, the losses given default are the same for

23

Chapter 2. Credit Derivatives Pricing Methods

each name in the portfolio. Let c denote the amount of loss that occurs when

N

i=1 c1τi ≤t

Zt =

M

1

= L(t)

N

where

N

L(t) = 1τi ≤t

i=1

E[min(Zt − Kj , 0)]

1

E[min(Zt − Kj , 0)] = E[min( L(t) − Kj , 0)]

N

1

= E[min(L(t) − NKj , 0)]

N

24

Chapter 2. Credit Derivatives Pricing Methods

the set {0, 1, . . . , N}. Therefore, we can write the expectation of interest as

1

E[min(Zt − Kj , 0)] = E[min(L(t) − NKj , 0)]

N

1

N

= P(L(t) = i) min(i − NKj , 0)]

N i=0

1

N

= P(L(t) = i)(i − NKj )

N i:i>N Kj

where P is the risk-neutral probability measure of the joint default of the ﬁrms

in the portfolio. Foreshadowing later chapters, one can see that computing the

CDOs.

general setting. Each credit derivative price, or spread, depends on the mod-

eling of the default time τ . In general, there are three diﬀerent approaches to

modeling the default time. The ﬁrst approach, called the structural model, links

the default time to the behavior of the company’s assets in relation to its debt.

The second approach, the intensity based model, models the default time as

25

Chapter 2. Credit Derivatives Pricing Methods

the ﬁrst jump time of a stochastic Poisson process. The third approach, copula

The next few sections introduce these diﬀerent approaches to pricing credit

Default in the ﬁrm value model has a very nice economical appeal. The ﬁrm

value approach, or structural model, models the total value of the ﬁrm that has

issued the defaultable bonds. Typically, the value of the ﬁrm includes the value

of equity (shares) and the debt (bonds) of the ﬁrm [27]. There are two main

approaches to modeling default in the ﬁrm value approach: one is that default

can only happen at the maturity of the bond and the second is that default can

We follow both [26, 3] and assume that the value of the ﬁrm, St , follows

geometric Brownian motion. However, more generally we can assume that the

value of the ﬁrm follows any diﬀusion process. We also assume that interest

26

Chapter 2. Credit Derivatives Pricing Methods

where r is the risk-free interest rate, and σ is constant volatility. At any time

We also assume that at time 0, the ﬁrm issued non-coupon corporate bonds

Γ̄(t, T ).

In [26] default was assumed to only occur at the expiration date T . Fur-

thermore, default at time T is triggered if the value of the ﬁrm is below some

Therefore, assuming zero recovery, the price of the defaultable bond satisﬁes,

Γ̄(t, T ) = E e−r(T −t) 1ST >B |St

= Γ(t, T )N(d2 )

St

ln + (r − 12 σ 2 )(T − t)

d2 = B

√

σ T −t

The next model, the Black-Cox model, is also known as the ﬁrst passage

approach. Developed in [3], default can occur anytime before the expiration of

the bond and the barrier level, B(t), is some deterministic function of time. In

27

Chapter 2. Credit Derivatives Pricing Methods

[3], they assume that the default barrier is given by the function B(t) = Keηt

deﬁned by

τ = inf {t : St ≤ B(t)}

That is, default happens the ﬁrst time the value of the ﬁrm passes below the

default barrier. This has the very appealing economical interpretation that

default occurs when the value of the ﬁrm falls below its debt level, thereby not

allowing the ﬁrm to pay oﬀ its debt and honor its obligations.

Γ̄(t, T ) = 1τ >t E e−r(T −t) 1τ >T |St

p

St −

= 1τ >t Γ(t, T ) N(d2 ) −

+

N(d2 )

B(t)

where

± ln + (r − η − 12 σ 2 )(T − t)

St

B(t)

d±

2 = √

σ T −t

2(r − η)

p = 1−

σ2

where we used a Girsanov change of measure above and results for the run-

28

Chapter 2. Credit Derivatives Pricing Methods

p

S0

P(τ ≤ t) = 1 − N(d+

2) − N(d−

2)

B(0)

Γ̄(t,T )

ln Γ(t,T )

Y (t, T ) = −

T −t

We remark that in the ﬁrst passage model above, and all ﬁrm value models,

the yield spread for very short maturities goes to 0 in contrast to the empirical

evidence [16]. This is because the default time τ deﬁned above is a predictable

cess for σ, [17] were able to raise the yield spread for short maturities.

The graph below shows an example of a credit spread curve in the structural

model:

29

Chapter 2. Credit Derivatives Pricing Methods

6

4

Spead (in percent)

0

0 1 2 3 4 5 6

Time to Maturity (years)

K = 50, r = .05, σ = .25, η = 0

requires more a mathematical set up than the structural based model that only

yond the scope of this dissertation. We encourage the reader to look at [27]

for many of the building blocks needed. Though we don’t include the basics of

30

Chapter 2. Credit Derivatives Pricing Methods

For the purpose of this section, we will only present Cox processes.

T n T

1

P(N(T ) − N(t) = n) = λ(s)ds exp − λ(s)ds

n! t t

The process N(t) can be considered a counting process that starts at zero.

to calculate

31

Chapter 2. Credit Derivatives Pricing Methods

= Γ(0, T )P(N(T ) = 0)

RT

= Γ(0, T )e− 0

λ(s)ds

problem. Since λ(s) is deterministic, we can’t correlate the spread with other

attention has been paid to developing stochastic intensity rate models. This

where the drift and volatility processes above are chosen such that λ(t) is

32

Chapter 2. Credit Derivatives Pricing Methods

Deﬁnition 2.3.2. A point process N(t) with intensity process λ(t) is a Cox pro-

This means that to compute things with this new process N(t), we will need

to use conditional expectations and the results presented above for inhomoge-

T n T

1

= E λ(s)ds exp − λ(s)ds

n! t t

= Γ(0, T )P(N(T ) = 0)

RT

= Γ(0, T )E[e− 0 λ(s)ds

]

33

Chapter 2. Credit Derivatives Pricing Methods

will allow us to price many diﬀerent expectations that are functions of the

t

2. Simulate the values 0

λi (s)ds, where λi (s) denotes N iid copies of the

original process λ.

Rt

τi = min{t > 0 : e− 0 λi (s)ds

≤ Ui }

Then, we have set of N iid default times (τi )1≤i≤N that can be used in a MC

34

Chapter 2. Credit Derivatives Pricing Methods

RT

P(τi ≤ T ) = P(e− 0

λi (s)ds

≤ Ui )

RT

= E[P(e− 0

λi (s)ds

≤ Ui |Ui )]

RT

= E[e− 0 λi (s)ds

]

RT

= E[e− 0

λ(s)ds

]

The type of diﬀusion λ(t) to use has been left intentionally vague. From the

is clear that not every non-negative diﬀusion process would give rise to behavior

that is exhibited in the credit market. As such, there is a great deal of research

on specifying diﬀerent models for λ(t) that try to capture the observed market

conditions.

For example, one such model is the Cox-Ingersoll-Ross (CIR) model that

dλ(t) = κ(θ − λ(t))dt + σ λ(t)dWt

The CIR model is mean reverting with θ being the mean-level and κ the

rate of mean-reversion. The λ(t) ensures that the intensity process stays

35

Chapter 2. Credit Derivatives Pricing Methods

credit derivatives under the dependence of defaults assumption. There are many

one can create correlation by correlating the driving Brownian motions between

C(1, . . . , 1, ui, 1, . . . , 1) = ui

36

Chapter 2. Credit Derivatives Pricing Methods

One of the most important theorems for copulas is Sklar’s theorem. Sklar’s

theorem enables one to separate a multivariate density into the marginals and

i = 1, . . . , n.

The critical interpretation of the above is that we can create any multi-

particular type of copula that has attracted a lot of attention and use in ﬁnancial

modeling.

37

Chapter 2. Credit Derivatives Pricing Methods

The Gaussian copula is the copula of choice for many ﬁnancial applications.

It became popular based on Li’s paper on default correlation modeling [10]. The

variables

Xi − μ i

Ui := Φ , i≤n

σi

function).

That is, it is very easy to simulate from and the dependency structure is more

clear than other families of copulas. To simulate from the Gaussian copula, one

1. Generate X1 , . . . , Xn with are jointly Φ0,R (·) normal distributed with mean

38

Chapter 2. Credit Derivatives Pricing Methods

2. Let

Ui = Φ(Xi ), ∀i ≤ n

U1 , . . . , Un are CR distributed.

Then these uniform random variables can be used, for example, to generate

section. That is, we replace the CR correlated random variables Ui with the

derivatives.

39

Chapter 3

and Interacting Particle Systems

sures

These path measures will be used throughout the rest of this dissertation and

will form the foundation for our analysis of ﬁnancial models presented in later

chapters.

sure. Second, a collection of potential functions that will provide a way to form

Boltzman-Gibbs measures.

40

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

We ﬁrst introduce some fundamental notation that will be needed for our

n ∈ N. The chain Xn takes values in some measurable state space (En , En ) with

We write,

Ω= En , F = (Fn )n∈N , X = (Xn )n∈N , Pμ

n≥0

chain takes values at each time n on En and has the elementary transitions Kn

with initial distribution μ, where μ is chosen from the space of all probability

Eμ (Fn (X0 , . . . , Xn )) = Fn (x0 , . . . , xn )Pμ,n (d(x0 , . . . , xn ))

E[0,n]

41

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

which follows directly from the fact that Xn is Markov with transitions given

by Kn .

We now turn our attention to the potential functions that will also be needed.

n

Eμ Gp (Xp ) >0

p=0

Deﬁnition 3.1.1. The Feynman-Kac prediction and updated path models asso-

ciated with the pair (Gn , Kn ) (and the initial distribution μ) are the sequence of

n−1

1

Qμ,n (d(x0 , . . . , xn )) = Gp (xp ) Pμ,n (d(x0 , . . . , xn )) (3.1)

Zn p=0

n

μ,n (d(x0 , . . . , xn )) = 1

Q Gp (xp ) Pμ,n (d(x0 , . . . , xn ))

Zn p=0

n−1 n

Zn = Eμ Gp (Xp ) and Zn = Zn+1 = Eμ Gp (Xp )

p=0 p=0

42

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

We also have the alternative deﬁnition for the measures Qμ,n that’s given

by,

1

n−1

Qμ,n (Fn ) = Eμ Fn (X0 , . . . , Xn ) Gp (Xp )

Zn p=0

n−1

Eμ (Fn ) = Zn Qμ,n Fn G−

p (3.2)

p=0

i.e., the measure is applied pointwise to the product of the functions where

G−

p = 1/Gp

under the original measure in terms of a new expectation under a diﬀerent path

measure and how to correct for it to ensure the two are equal. This relationship

will play a pivotal role in determining the change of measure to use later.

43

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

n−1

γn (fn ) = Eμ fn (Xn ) Gp (Xp )

p=0

and

n

γn (fn ) = Eμ fn (Xn ) Gp (Xp )

p=0

are respectively called the unnormalized prediction and the updated Feynman-

Kac model associated with the pair (Gn , Kn ). The sequence of distributions ηn

ηn (fn ) = γn (fn )/γn (1) and ηn (fn ) = γn (fn )/

γn (1) (3.3)

In fact, there are several properties and connections between the various

equations above that are worth exploring. Firstly, note that for n = 0, we have

n

Zn = Zn+1 =

γn (1) = γn+1 (1) = Eμ Gp (Xp )

p=0

In addition,

44

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

n−1

γn (fn Gn ) = Eμ fn (Xn )Gn (Xn ) Gp (Xp ) =

γn (fn )

p=0

ηn (fn ) = = =

γn (Gn ) γn (Gn )/γn (1) ηn (Gn )

n−1

n

γn (fn ) = ηn (fn ) ηp (Gp ) and

γn (fn ) = ηn (fn ) ηp (Gp )

p=0 p=0

P(E) denote the space of probability measures on a given measure space (E, E).

from the subset Ψn (En ) = {η ∈ P(En ); η(Gn ) > 0} into itself and deﬁned for

1

Ψn (η)(dxn ) = Gn (xn )η(dxn )

η(Gn )

45

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

sures

Section 3.1 presented the notation and general class of Feynman-Kac models

that will form the foundation for the interacting particle system we will develop

the results of Feynman-Kac path measure theory that are instrumental for our

model development.

The results presented in Section 3.1 were presented for a general non-homogenous

Let

def. def.

Yn = (X0 , . . . , Xn ) ∈ Fn = (E0 × · · · × En )

Let Mn (yn−1 , dyn ) be the Markov transitions associated with the chain Yn .

γn (fn ) = E fn (Yn ) Gk (Yk ) (3.4)

1≤k<n

46

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

E fn (Yn ) 1≤k<n Gk (Yk )

ηn (fn ) = = γn (fn )/γn (1) (3.5)

E 1≤k<n Gk (Yk )

In addition, in [12] they assume that the potential functions are chosen such

that

(yn ,ȳn )∈Fn2

However, the authors note that this condition can be relaxed by considering

traditional cut-oﬀ techniques, among other techniques (see [12, 11] for more

details).

Kac distributions ηn and ηn associated with the pair (Gn , Mn ) satisfy the non-

n (

linear recursive equations ηn = Φn (ηn−1 ) and ηn = Φ ηn−1 ) with the mappings

Φn and Φ

n (η) = Ψn (ηMn ) = Ψ

Φn (η) = Ψn−1 (η)Mn and Φ n−1 (η)M

n

Ψn and Ψ

Gn (xn )

Ψn (μ)(dxn ) = n (μ)(dxn ) = Gn (xn ) μ(dxn )

μ(dxn ) and Ψ

μ(Gn ) μ(Gn)

47

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

n , M

The pair potentials/kernels (G n ) are deﬁned for any fn ∈ Bb (Fn ) by the

formula

G n (fn ) = Mn (fn Gn )/Mn (Gn )

The results in Proposition 3.2.1 can also be written in the equivalent integral

form

def.

ηn = Φn (ηn−1 ) = ηn−1 (dyn−1 )Gn−1 (yn−1)Mn (yn−1 , ·)/ηn−1(Gn−1 )

Fn−1

model

updating prediction

Ψn−1 (ηn−1 )(dxn ) to the known measure ηn−1 followed by the “prediction” that’s

48

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

which is known. In addition, the chain Yn has Markov transitions given by the

kernel Mn . Then, following the notation in Section 3.1 and using the Markov

property we have

We call the measure in Equation 3.6 the original measure because we have

assumed that the kernels are known explicitly (or at least how to sample from

them).

Recall that the normalized distributions associated with the pair (Gn , Mn )

is given by

n−1

1

ηn (d(x0 , y1, . . . , yn )) = Gp (yp ) Pμ,n (d(x0 , y1 , . . . , yn ))

γn (1) p=0

49

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

n−1

n−1

Eμ,n (fn (Yn )) = Eμ,n fn (Yn ) G−

p (Yp ) Gp (Yp )

p=0 p=0

n−1

= γn (fn G−

p)

p=0

n−1

n−1

= ηn (fn G−

p) ηp (Gp )

p=0 p=0

n−1

n−1

n−1

ηn (fn G−

p) = Eηn (fn (Yn ) G−

p (Yp )) = fn (yn ) Gp (yp )ηn (d(x0 , y1, . . . , yn ))

p=0 p=0 Fn p=0

ηp (Gp ) = Eηp (Gp (Yp )) = Gp (yp )ηp (d(x0 , y1 , . . . , yp))

Fp

able to sample from them for a numerical scheme. However, Proposition 3.2.1

tells us exactly the prescription that’s needed. The power lies in the fact that

at each time step n the recursive relationship only depends on ηn−1 , which is

also known, the circle is complete and we have a clear way to proceed.

50

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

we are able to compute things explicitly, its real strength will be shown when

we aren’t able to solve the recursive equation explicitly and have to rely on

of Feynman-Kac Models

where the changes of measure can’t be explicitly computed. The idea can be

Kac measures empirically. After such a development, we will analyze the rate of

with the pair (Gn , Mn ) satisﬁes the nonlinear recursive equation ηn = Φn (ηn−1 ),

where

51

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

and

Gn (xn )

Ψn (μ)(dxn ) = μ(dxn )

μ(Gn )

where,

Gn (xn )

Ψn (ηn ) = ηn (dxn )

ηn (Gn )

symbolic form

where

52

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

We note that in this notation, Kn+1,ηn represents the Markov transition for

Ω(N ) = FnN , F N = (FnN )n∈N , ξ (N ) = (ξn(N ) )n∈N , PN

η0

n≥0

! "

N times

(N )

The initial conﬁguration ξ0 consist of N independent and identically dis-

tributed random variables with common law η0 . Its elementary transitions from

N

Fn−1 into FnN are given in a symbolic integral form by

N

(N ) (N,p)

PN

η0 ξn ∈ dxn |ξn−1 =

(N )

Kn, 1 PN (ξn−1 , dxpn ) (3.9)

N i=1 δξ(N,i)

p=1 n−1

n is an inﬁnitesimal neighborhood of a point xn =

n ) ∈ Fn

(x1n , . . . , xN N

53

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

1

N

m(xn ) = δxi

N i=1 n

for each xn = (xn )i1≤i≤N ∈ FnN . Then, we can write Equation (3.9) in the

N

(N ) p

PN

η0 ξ (N )

n ∈ dx |ξ

n n−1 = Kn,m(ξn−1 ) (ξn−1 , dxpn )

p=1

Recalling the deﬁnition of Kn,η for our problem, we can write the above

equation as

N

(N ) p

PN

η0 ξn ∈ dxn |ξn−1 =

(N )

(Sn,m(ξn ) )Mn+1 (ξn−1 , dxpn )

p=1

(N )

PN

η0 ξn(N ) ∈ dxn |ξn−1 = Sn (ξn , dxn )Mn+1 (xn , dxn+1 ) (3.10)

FnN

where,

N

Sn (ξn , dxn ) = Sn,m(ξn ) (ξnp , dxpn )

p=1

N

Mn+1 (xn , dxn+1 ) = Mn+1 (xpn , dxpn+1 )

p=1

54

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

is the Boltzman-Gibbs transformation from FnN into itself and the mutation

N

, respectively.

Interpreting the above deﬁnitions and equations is critical to form the correct

can replace

Sn,η Mn+1

ηn ∈ P(Fn ) −→n ηn = ηn Sn,ηn ∈ P(Fn ) −→ ηn+1 = ηn+1 Mn+1

selection mutation N

where the selection and mutation transition is given by the following algo-

rithm:

55

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

N

Gn (ξni )

Ψn (m(ξn )) = n j δξn

i

i=1 j=1 G n (ξ n )

Note that selecting each particle ξni is done independently of one another

selected the new N particles, ξn = (ξni )1≤i≤N ∈ FnN , we mutate each par-

i

prescribed by Mn+1 . That is, we sample independently N particles, ξn+1 ,

with respective distribution Mn+1 (ξni , ·). The new set of particles is de-

i

noted by ξn+1 = (ξn+1 )1≤i≤N ∈ Fn+1

N

.

Building from previous sections, we recall that we have the following repre-

n−1

γn (fn ) = ηn (fn ) ηp (Gp )

p=0

Given the above algorithm, the particle approximation measures for (γn , ηn )

are deﬁned by

56

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

n−1

1

N

γnN (·) = ηpN (Gp ) × ηnN (·) with ηnN = δ i i

p=0

N i=1 (ξ0,n ,...,ξn,n )

on the results in [12] as this article directly analyzes interacting particle systems

for rare events. These convergence results, including the proof of the unbiased-

ness for IPS estimators, will be used directly in later chapters to analyze our

As mentioned in the previous paragraph, [12] analyzes the use of IPS for

contained in [12] for completeness as they will be pivotal for the results we

present later.

the local sampling errors of the particle approximation steps. As such, we deﬁne

57

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

√

WnN (fn ) = N[ηnN − Φn (ηn−1

N

)](fn )

for any test function fn ∈ Bb (Fn ). Then we have the following central limit

Theorem 3.5. For any ﬁxed time horizon n ≥ 1, the sequence (WpN )1≤p≤n

and centered random ﬁelds (Wp )1≤p≤n ; with, for any fp , gp ∈ Bb (Fp ) and 1 ≤

p ≤ n,

Qp,n (fn )(yp ) = E fn (Yn ) Gk (Yk )|Yp = yp

p≤k<n

for any fn ∈ Bb (Fn ) and any path sequence yp = (x0 , . . . , xp ) ∈ Fp with the

58

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

γn = γp Qp,n

γn (fn ) = E fn (Yn ) Gk (Yk )

1≤k<n

= E Gk (Yk ) × E fn (Yn ) Gk (Yk )|(Y0, . . . , Yp )

1≤k<p p≤k<n

γn (fn ) = E Gk (Yk ) × E fn (Yn ) Gk (Yk )|Yp

1≤k<p p≤k<n

= E Gk (Yk ) Qp,n (fn )(Yp ) = γp Qp,n (fn )

1≤k<p

The reason for having the above lemma is to make the telescopic decompo-

sition

n

γnN − γn = [γpN Qp,n − γp−1

N

Qp−1,n ]

p=1

59

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

Recall that for p = 1, we have η0N = δx0 and γ1 = η1 = M1 (x0 , ·). This

N

γp−1 N

Qp−1,p = ηp−1 (Gp−1 ) × Φp−1 (ηp−1

N N

) and γp−1 (Gp−1 ) = γpN (1)

def. √ n

Wnγ,N (fn ) = N [γnN − γn ](fn ) = γpN (1)WpN (Qp,n fn ) (3.11)

p=1

Lemma 3.5.2. γnN is an unbiased estimate for γn , in the sense that for any

√

E(γnN (fn )) = γn (fn ) and sup N E[|γnN (fn ) − γn (fn )|p ]1/p ≤ cp (n)

N ≥1

for some constant cp (n) < ∞ whose value does not depend on the function fn .

Proof. See [12] for the complete proof. We include the ﬁrst part for illustrative

purposes.

First, notice that (γnN (1))n≥1 is a predictable sequence, in the sense that

n−1

n−1

E(γnN (1)|ξ0 , . . . , ξn−1) =E ηpN (Gp )|ξ0 , . . . , ξn−1 = ηpN (Gp ) = γnN (1)

p=1 p=1

60

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

√

= N E([ηpN − Φp (ηp−1

N

)](Qp,n fn )|ξ0 , . . . , ξp−1) = 0

def. √ n

Wnγ,N (fn ) = N[γnN − γn ](fn ) = γpN (1)WpN (Qp,n fn )

p=1

we ﬁnd

n

1

E([γnN − γn ](fn )) = √ E γpN (1)WpN (Qp,n fn )

N p=1

1

n

= √ E(γpN (1)WpN (Qp,n fn ))

N p=1

= 0

61

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

Lemma 3.5.2 is important because it shows that as N goes to inﬁnity, the ran-

dom sequence (γpN (1))1≤p≤n converges to the deterministic sequence (γp (1))1≤p≤n

n

Wnγ (fn ) = γp (1)Wp (Qp,n fn ) (3.12)

p=1

We end this section by presenting the major theorem that was developed in

[12] for analyzing the asymptotic variance of the IPS estimators for rare event

where Vn ∈ En → R is some function and the value a is chosen such that the

above probability is extremely small (i.e. Pn (a) ∈ [10−12 , 10−6 ]). Recall that

62

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

develop an IPS routine to estimate Pn (a) and analyze the resulting variance.

functions (Gk )1≤k≤n that satisfy the conditions stated in Section 3.2 we can

= E 1Vn (Xn )≥a G−

k (Yk ) Gk (Yk )

1≤k<n 1≤k<n

= γn 1Vn (Xn )≥a G−

k (Yk )

1≤k<n

= γn (Tn(a) (1))

= ηn (Tn(a) (1)) ηk (Gk )

1≤k<n

(a)

where we deﬁne Tn for any path yn = (x0 , . . . , xn ) by

Tn(a) (1)(yn ) = Tn(a) (1)(x0 , . . . , xn ) = 1Vn (xn )≥a G−

k (x0 , . . . , xk )

1≤k<n

63

Chapter 3. Feynman-Kac Path Measures and Interacting Particle Systems

PnN (a) = ηnN (Tn(a) (1)) ηkN (Gk )

1≤k<n

1

N

= 1Vn (Xni )≥a G− i i i

k (X0 , X1 , . . . , Xk ) ηkN (Gk )

N i=1 1≤k<n 1≤k<n

Theorem 3.6. The estimator PnN (a) is unbiased, and it satisﬁes the central

limit theorem

√ N →∞

N [PnN (a) − Pn (a)] → N(0, σnγ (a)2 ) (3.13)

n

σnγ (a)2 = [γp (1)γp− (1)ηp− (Pp,n (a)2 ) − Pn (a)2 ]

p=1

n

= [γp (1)γp− (Pp,n (a)2 ) − Pn (a)2 ] (3.14)

p=1

xp ∈ Ep

→ Pp,n (a)(xp ) = E[1Vn (Xn )≥a |Xp = xp ] ∈ [0, 1] (3.15)

64

Chapter 4

Interacting Particle Systems

4.1 Introduction

by an exogenously deﬁned process, default in the ﬁrm value model has a very

nice economical appeal. The ﬁrm value approach, or structural model, models

the total value of the ﬁrm that has issued the defaultable bonds. Typically, the

value of the ﬁrm includes the value of equity (shares) and the debt (bonds) of the

ﬁrm [27]. There are two main approaches to modeling default in the ﬁrm value

approach: one is that default can only happen at the maturity of the bond, and

the second is that default can occur any time before maturity. We have chosen

to focus on the ﬁrm value approach, and speciﬁcally the ﬁrst passage approach,

65

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

by applying IPS, one has to choose potential functions (the Gk ’s) that closely

mimics the behavior of the random variable that precedes the rare event. As

will be shown, the ﬁrst passage model admits a very natural choice of weight

function to use.

have chosen to formulate our approach in the context of a ﬁrst passage model.

and not on the calibration of the model. As such, we assume that our model

has been calibrated to market data and that the pricing that is needed exhibit

encourage the reader to see [5] for information regarding the calibration of a

sections occur under the original measure. That is, to achieve the variance

reduction, one does not have to compute a change of measure explicitly. Rather,

the change of measure is performed in path space through the IPS algorithm

of selection and mutation. The important point is that the simulation of the

66

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

one of the most powerful and popular variance reduction techniques, importance

on the maturity time T in the new dynamics. This dependence means that each

maturity date needs its own simulation. IPS doesn’t suﬀer from this problem

and we will show how to use the same simulation to compute the tranche spreads

We follow both [26, 3] and assume that the value of the ﬁrm, St , follows

geometric Brownian motion. We also assume that interest rates are constant.

where r is the risk-free interest rate, and σ is constant volatility. At any time

67

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

We also assume that at time 0, the ﬁrm issued non-coupon corporate bonds

Γ̄(t, T ).

In [26] default was assumed to only occur at the expiration date T . Fur-

thermore, default at time T is triggered if the value of the ﬁrm was below some

Γ̄(t, T ) = E e−r(T −t) 1ST >B |St

= Γ(t, T )N(d2 )

S

ln t

+ (r − 12 σ 2 )(T − t)

d2 = B

√

σ T −t

The next model, the Black-Cox model, is also known as the ﬁrst passage ap-

proach. Developed in [3], default can occur anytime before the expiration of

the bond and the barrier level, B(t), is some deterministic function of time. In

[3], they assume that the default barrier is given by the function B(t) = Keηt

68

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

deﬁned by

τ = inf {t : St ≤ B(t)}

That is, default happens the ﬁrst time the value of the ﬁrm passes below the

default barrier. This has the very appealing economical interpretation that

default occurs when the value of the ﬁrm falls below its debt level, thereby not

Γ̄(t, T ) = 1τ >t E e−r(T −t) 1τ >T |St

p

St −

= 1τ >t Γ(t, T ) N(d2 ) −

+

N(d2 )

B(t)

where

± ln + (r − η − 12 σ 2 )(T − t)

St

B(t)

d±

2 = √

σ T −t

2(r − η)

p = 1−

σ2

1− 2r2

St σ

P B (t, T ) = 1 − 2)−

N(d+ N(d−

2) (4.2)

B

69

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

For our purposes, we consider a CDO written on N ﬁrms under the ﬁrst

passage model. That is, we assume that the ﬁrm values for the N names have

where r is the risk-free interest rate, σi is constant volatility, and the driving

correlation

d Wi , Wj t = ρij dt.

Each ﬁrm i is also assumed to have a deterministic boundary process Bi (t) and

N

L(T ) = 1{τi ≤T } (4.5)

i=1

That is, L(T ) counts the number of ﬁrms among the N ﬁrms that have de-

folio case, with constant barrier, the distribution of L(T ) is Bin(N, P B (0, T ))

70

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

Recall that for a homogeneous portfolio, it is well known that the spread

form,

E{(L(Ti ) − Kj )+ }

the names in the portfolio are correlated. In [29], the distribution of losses for

modiﬁed Bessel functions and a general result for N > 2 has yet to be found.

Since the distribution of L(T ) isn’t known in the dependent case, for N > 2, MC

methods are generally used to calculate the spread on the tranches. Since N

P(L(T ) = i) = pi (T ) i = 0, . . . , N (4.6)

71

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

In this manner, we will then be able to calculate all expectations that are a

function of L(T ), not just the spreads. In addition, as the reader will see, our

where the change of measure has a dependence on the ﬁnal time through the

date.

tem interpretation, are closely related to the stochastic ﬁltering techniques used

the authors develop a general interacting particle system method for calculat-

72

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

mutation-selection algorithm so that the chain is “forced” into the rare event

regime.

For the sake of the reader, we review the most important components of

more detail.

(X̃t )t∈[0,T ] . However, for the variance analysis and to foreshadow the method

ahead, we only consider the chain (Xp )0≤p≤n = (X̃pT /n )0≤p≤n , where n is ﬁxed.

The chain Xn takes values in some measurable state space (En , En ) with Markov

is

def. def.

Yn = (X0 , . . . , Xn ) ∈ Fn = (E0 × · · · × En )

Let Mn (yn−1, dyn ) be the Markov transitions associated with the chain Yn . Let

Bb (E) denote the space of bounded, measurable functions with the uniform

norm on some measurable space (E, E). Then, given any fn ∈ Bb (Fn ), and the

measure deﬁned by

γn (fn ) = E f (Yn ) Gk (Yk ) (4.8)

1≤k<n

73

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

E f (Yn ) 1≤k<n Gk (Yk )

ηn (fn ) = = γn (fn )/γn (1) (4.9)

E 1≤k<n Gk (Yk )

In addition, in [12] they assume that the potential functions are chosen such

that

(yn ,ȳn )∈Fn2

However, the authors note that this condition can be relaxed by considering

traditional cut-oﬀ techniques, among other techniques (see [12, 11] for more

details).

n

γn+1(1) = γn (Gn ) = ηn (Gn )γn (1) = ηp (Gp )

p=1

γn (fn ) = ηn (fn ) ηp (Gp )

1≤p<n

will also make use of the distribution ﬂow (γn− , ηn− ) deﬁned exactly the same

G−

p = 1/Gp

74

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

Then, using the deﬁnition for γn and ηn it is easy to see that E[fn (Yn )] admits

E [fn (Yn )] = E fn (Yn ) G−

p (Yp ) × Gp (Yp )

1≤p<n 1≤p<n

= γn fn G−

p

1≤p<n

= ηn fn G−

p ηp (Gp )

1≤p<n 1≤p<n

Finally, it can be checked that the measures (ηn )n≥1 satisfy the nonlinear recur-

sive equation

def.

ηn = Φn (ηn−1 ) = ηn−1 (dyn−1 )Gn−1 (yn−1)Mn (yn−1 , ·)/ηn−1(Gn−1 )

Fn−1

eral Algorithm

The above deﬁnitions and results lend themselves to a very natural inter-

in the product space FnM with transformation Φn by ξn = (ξni )1≤i≤M , for each

path-particle

ξni = (ξ0,n

i i

, ξ1,n i

, . . . , ξn,n ) ∈ Fn = (E0 × · · · × En )

75

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

def. i

i.e., ξ1i = (ξ0,1 i

, ξ1,1 i

) = (x0 , ξ1,1 ) ∈ F1 = (E0 × E1 ). Then, the elementary

M

into FnM are deﬁned by

M

P(ξn ∈ d(yn1 , . . . , ynM )|ξn−1) = Φn (m(ξn−1 ))(dyni ), (4.10)

i=1

def. 1 M

where m(ξn−1 ) = M i=1 δξn−1

i , and d(yn1 , . . . , ynM ) is an inﬁnitesimal neighbor-

hood of the point (yn1 , . . . , ynM ) ∈ Fnm . From the deﬁnition of Φn , one can see

M selection ˆ M mutation

ξn−1 ∈ Fn−1 −→ ξn−1 ∈ Fn−1 −→ ξn ∈ FnM

path-particles

ξˆn−1

i

= (ξˆ0,n−1

i

, ξˆ1,n−1

i

, . . . , ξˆn−1,n−1

i

) ∈ Fn−1

M j

Gn−1 (ξ0,n−1 j

, . . . , ξn−1,n−1 )

M i i

δ(ξj j

0,n−1 ,...,ξn−1,n−1 )

j=1 i=1 Gn−1 ((ξ0,n−1 , . . . , ξn−1,n−1 )

76

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

i

is extended by

ξni = ((ξ0,n

i i

, . . . , ξn−1,n i

), ξn,n )

= ((ξˆ0,n

i

, . . . , ξˆn−1,n

i i

), ξn,n ) ∈ Fn = Fn−1 × En

i

where ξn,n is a random variable with distribution Kn (ξˆn−1,n−1

i

, ·). In other words,

the transition is made by applying the original kernel Kn . All of the mutations

are performed independently. We just quote the results from [11, 12] in stating

1

M

def. N →∞

ηnM = i ,ξ i ,...,ξ i ) −→ ηn

δ(ξ0,n n,n

M i=1 1,n

Furthermore, there are several propagation of chaos estimates that ensure that

i i i

(ξ0,n , ξ1,n , . . . , ξn,n ) are asymptotically independent and identically distributed

γnM deﬁned as

γnM (fn ) = ηnM (fn ) ηpM (Gp )

1≤p<n

Lemma 4.3.1 ([12]). γnM is an unbiased estimator for γn , in the sense that for

√

E(γnM (fn )) = γn (fn ) and sup M E[|γnM (fn ) − γn (fn )|p ]1/p ≤ cp (n)

M ≥1

for some constant cp (n) < ∞ whose value does not depend on the function fn .

77

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

Our Markov process is the 3 × N dimensional process (X̃t )t∈[0,T ] deﬁned as:

X̃t = (S1 (t), min S1 (u), 1τ1 ≤t , S2 (t), min S2 (u), 1τ2 ≤t , · · ·

u≤t u≤t

u≤t

where the dynamics of Si (t) are given in Equation (4.3). We assume a constant

1τi ≤t in the above expression since we also know minu≤t Si (u), we keep track of

it because it will tell us the default time of the ﬁrm when we implement the

algorithm numerically. We divide the time interval [0, T ] into n equal intervals

[ti−1 , ti ], i = 1, 2, . . . , n. These are the times we stop and do the selection and

mutation. We introduce the chain (Xp )0≤p≤n = (X̃pT /n )0≤p≤n and the whole

Since it isn’t possible to sample directly from the distribution of (Xp )0≤p≤n

for N > 2, we will have to apply an Euler scheme during the mutation stage;

78

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

we let t denote the suﬃciently small time step used. In general t will be

Our general strategy is to ﬁnd a potential function that increases the likeli-

hood of default among the ﬁrms. In the IPS algorithm, given a particular choice

of weight function G(·), particles with low scores are replaced by particles with

high scores. Therefore, we would like to select a potential function G(·) that

progressively only selects the particles whose ﬁrms are defaulting. Since the rare

event in this case is that the minimum of the ﬁrm value falls below a certain

level, we would like to put more emphasis on particles whose ﬁrm minimums

where

N

V (Xp ) = log(min Si (u))

u≤tp

i=1

negative because the potential function Gα (Yp ) can be written in the form,

N

= exp α log min(Si (u)/ min Si (u)

u≤tp u≤tp−1

i=1

79

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

where,

log min(Si (u))/ min Si (u) ≤0

u≤tp u≤tp−1

Therefore, to place more weight on the ﬁrms whose minimum has decreased, we

There are several comments about this weight function that should be ad-

dressed.

For the moment, we only consider one ﬁrm name (N = 1) and drop the

log min(S(u))/ min S(u) ≤ 0

u≤tp u≤tp−1

However,

log min S(u)/ min S(u) = 0 ⇐⇒ min S(u) = min S(u)

u≤tp u≤tp−1 u≤tp u≤tp−1

and

80

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

log min S(u)/ min S(u) < 0 ⇐⇒ min S(u) < min S(u)

u≤tp u≤tp−1 u≤tp u≤tp−1

α

G (Yp ) = exp α log min S(u)/ min S(u)

u≤tp u≤tp−1

⎧

⎪

⎪

⎪

⎨1, if minu≤tp S(u) = minu≤tp−1 S(u),

=

⎪

⎪

⎪

⎩> 1, if minu≤tp S(u) < minu≤tp−1 S(u),

Therefore, the particles whose minimums have not decreased in the last time

step will have a weight function value of 1. The particles whose minimums have

decreased greatly in the last time step will have a weight value greater than 1.

In addition, the more negative α is and the greater the decrease, the higher the

weight function value will be. Therefore, since we are sampling more frequently

from the particles with a large weight function value, we will be sampling from

the particles whose minimum has decreased the most. Thereby, we will be

putting more weight on the trajectories that are approaching the rare event

region.

81

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

1. Our choice of weight function, while not unique in this regard, will only

an IPS scheme.

2. In addition, our weight function has the added advantage of having the

property that 1≤k<p G(Yk ) = exp[α(V (Xp−1 )−V (X0 ))] thereby ensuring

that the Feynman-Kac measures deﬁned in equations (6.6) and (6.7) are

Our algorithm is built with the weight function deﬁned in Equation (4.11).

(i)

Initialization. We start with M identical copies, X̂0 , 1 ≤ i ≤ M, of the

(i)

X̂0 = (S1 (0), S1 (0), 0, S2(0), S2 (0), 0, · · · , SN (0), SN (0), 0), 1 ≤ i ≤ M

We also have a set of “parents”, Ŵ0 , deﬁned by Ŵ0 = X̂0 . We denote

def. (i) (i) (i)

V0 = V (Ŵ0 ). This forms a set of M particles (Ŵ0 , X̂0 ), 1 ≤ i ≤ M.

(i) (i)

Now suppose that at time p, we have the set of M particles (Ŵp , X̂p ),

1 ≤ i ≤ M.

Selection Stage

82

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

1

M # $

η̂pM = exp α V (X̂p(i) ) − V (Ŵp(i) ) (4.12)

M i=1

tribution,

1

M # $

ηpM (dW̌ , dX̌) = exp α V (X̂p ) − V (Ŵp ) × δ(Ŵp(i) ,X̂p(i) ) (dW̌ , dX̌)

(i) (i)

M η̂pM i=1

(4.13)

(i) (i)

The particles that are selected are denoted (W̌p , X̌p ).

Mutation Stage

(i) (i)

For each of the selected particles, (W̌p , X̌p ), we apply an Euler scheme

(i) (i)

from time tp to time tp+1 with step size
t for each X̌p so that X̌p becomes

(i) (i) (i)

X̂p+1 . We then set Ŵp+1 = X̌p . It should be noted, that each of the particles

are evolved independently and that the true dynamics (given in equation (4.3))

of Xp are applied rather than some other measure. It is this fact that separates

Then let,

N

f (X̂n(i) ) = 1{min (i)

Sj (u)≤Bj }

u≤T

j=1

83

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

denote the number of ﬁrms that have defaulted by time T for the ith particle.

n−1

1 M

PjM (T ) = 1f (X̂n(i) )=j exp(−α(V (Ŵn(i) ) − V0 )) × η̂pM (4.14)

M i=1 p=1

Obligations

From the above formulation, we can immediately see how the pricing of the

CDO occurs with IPS. Suppose that {T1 , . . . , TK } is the set of coupon dates.

Recall from Chapter 2 that the spread for each tranche is given by functions

84

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

At ﬁrst glance, this may not seem to be that novel. However, as mentioned

before, IPS is dynamically consistent in time. This means that we can use the

same simulation to compute PjM (T1 ) as we use to compute PjM (TK ). This is in

direct contrast to the most used form of variance reduction; importance sam-

the maturity time T through the Girsanov change of measure. Therefore, given

maturity. However, since IPS simulates under the original measure, there is no

fore, we run the IPS algorithm until time T1 and form the vector (PjM (T1 ))1≤j≤N

and then continue the simulation and IPS algorithm until time T2 . We continue

of the variance of the estimator. Since there are many such unbiased estima-

tors, the key is analyzing the variance of the estimator. To analyze the variance

of equation (4.14), the reader would need to know the multidimensional dis-

tribution of the stock prices and their running minimum. As mentioned, this

85

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

distribution is not known. Therefore, we analyze the more simple case where

computing, using IPS, the probability of default before maturity T . That is, we

compute

u≤T

because we have an explicit formula for which to compare our results. The

more general case, where N is large and the names are correlated, will just be

analyzed numerically as there aren’t even formulas for traditional MC. It should

be noted that we are only interested in values of B that make the above event

rare.

the traditional MC method for computing P B (0, T ) is P B (0, T )(1 − P B (0, T )).

We also remark that the Markov chain (Xp )0≤p≤n deﬁned in Section 4.4

simpliﬁes to

u≤tp

86

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

Then, following the setup described in Section 4.3, we see that the rare event

(B)

Where Ln (1) is given by the weighted indicator function deﬁned for any path

yn = (x0 , . . . , xn ) ∈ Fn by

L(B) (B)

n (1)(yn ) = Ln (1)(x0 , . . . , xn ) = 1{minu≤tn S(u)≤B} G−

p (x0 , . . . , xp )

1≤p<n

(B)

||Ln (1)(yn )|| ≤ 1 since log(minu≤tn−1 S(u)/S0) ≤ 0 and −α > 0 by assumption.

Therefore, if we let

B

PM (0, T ) = γnM (L(B) M (B)

n (1)) = ηn (Ln (1)) ηpM (Gp ) (4.16)

1≤p<n

B

then we see that by Lemma 4.3.1, PM (0, T ) is an unbiased estimator of P B (0, T )

such that

M →∞

B

PM (0, T ) −→ P B (0, T ) a.s.

While many estimators are unbiased, the key to determining the eﬃciency of

our estimator is to look at it’s variance. As such, we have the following central

87

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

Theorem 4.6. The estimator PBM (0, T ) given in equation (4.16) is unbiased,

√ M →∞

M E[PM

B

(0, T ) − P B (0, T )] −→ N(0, σnB (α)2 )

σnB (α)2

n # %

& % & $

α log(minu≤tp−1 S(u)) −α log(minu≤tp−1 S(u))

= E e × E PB,p,n e

2

− P (0, T )

B 2

p=1

(4.17)

' (

PB,p,n (x) = E 1minu≤T S(u)≤B |Xp = x

Proof. The proof follows directly by applying Theorem 2.3 in [12] with the

√ √

B

M [PM (0, T ) − P B (0, T )] = M [γnM (Ln(B) (1)) − P B (0, T )]

88

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

(B)

where Ln (1) is the weighted indicator function deﬁned in Equation 4.15.

n

Wnγ,M (fn ) = γpM (1)WpM (Qp,n fn )

p=1

(B)

Therefore, taking fn = Ln (1) in Equation 3.11 and Equation 3.12 we have

(B)

that Wnγ,M (Ln (1)) converges in law, as N goes to inﬁnity, to a centered Gaus-

(B)

sian random variable Wnγ (Ln (1)) with variance

n (1)) )

n

γp (1)2 ηp ([Qp,n (L(B) (B) 2

=

p=1

Qp,n (fn )(yp ) = E fn (Yn ) Gk (Yk )|Yp = yp

p≤k<n

(B)

and substituting fn = Ln (1) and

Gk (Yk ) = eα log(minu≤tk S(u)/ minu≤tk−1 S(u)) (4.18)

p≤k<n p≤k<n

we ﬁnd that

89

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

−α log(minu≤tp−1 S(u)/S0 )

Qp,n (L(B)

n (1))(y p ) = E 1{minu≤tn S(u)≤B} e |Y p = y p

= e−α log(minu≤tp−1 S(u)/S0 ) E 1{minu≤tn S(u)≤B} |Yp = yp

= e−α log(minu≤tp−1 S(u)/S0 ) E 1{minu≤tn S(u)≤B} |Xp = xp

u≤tn

where we used the Markov property on the second to last line. Recall that

u≤tn

= P B (0, T )/γp(1)

γp (1) = E( Gk (Yk ))

1≤k<p

α log(minu≤tk S(u)/ minu≤tk−1 S(u))

= E e

1≤k<p

= E eα log(minu≤tp−1 S(u)/S0 )

Therefore, combining the above results and plugging them into the formula

90

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

σnB (α)2

n

γp (1)2 ηp ([Qp,n (L(B) (B) 2

=

p=1

n

= γp (1)2 ηp ([e−α log(minu≤tp−1 S(u)/S0 ) P(min S(u) ≤ B|Xp = xp ) − P B (0, T )/γp (1)]2 )

u≤tn

p=1

n

−2α log(minu≤tp−1 S(u)/S0 )

= γp (1) 2

ηp (e P(min S(u) ≤ B|Xp = xp ) ) − P (0, T ) /γ (1)

2 B 2 2

u≤tn

p=1

n

−α log(minu≤tp−1 S(u)/S0 )

= γp (1)E e P(min S(u) ≤ B|Xp = xp ) − P (0, T )

2 B 2

u≤tn

p=1

n #

α log(minu≤tp−1 S(u)/S0 ) −α log(minu≤tp−1 S(u)/S0 )

= E e E e P(min S(u) ≤ B|Xp = xp ) 2

u≤tn

p=1

$

−P B (0, T )2

n # %

& % & $

α log(minu≤tp−1 S(u)) −α log(minu≤tp−1 S(u))

= E e × E PB,p,n e

2

− P (0, T )

B 2

p=1

' (

PB,p,n (x) = E 1minu≤T S(u)≤B |Xp = x

The above theorem gives the asymptotic variance of the single-name estima-

expression for the variance that will be useful to compare with traditional MC.

91

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

Corollary 4.6.1. Given the choice of weight function in Equation (4.11) and

n ( σ1 ) ln(B/S0 ) 0 ∞

− 12 θ 2 tp

= f (α, tp−1)e e−ασx+θz Ψ(tp−1 ,tp ) (x, y, z)dzdxdy

p=1 −∞ y y

( σ1 ) ln(B/S0 ) ∞

+ e−ασx+θz Υ(tp−1 ,tp ) (x, z)dzdx

−∞ x

0 0 ∞

+ h(tp , z)2 e−ασx+θz Ψ(tp−1 ,tp ) (x, y, z)dzdxdy

( σ1 ) ln(B/S0 ) y y

0 ∞

+ h(tp , z)2 e−ασx+θz Υ(tp−1 ,tp ) (x, z)dzdx

( σ1 ) ln(B/S0 ) x

1− 2r2 2

S0 σ

− 1 − N(d+

2 (0, 0)) + N(d−

2 (0, 0))

B

(4.21)

where,

f (α, tp−1)

√ √

ασ + θ ασ(ασ+2θ)tp−1 /2 (ασ + θ) tp−1 θ −θ tp−1

= e Erfc √ + Erfc √

ασ + 2θ 2 ασ + 2θ 2

∞

2 2

Erfc(x) = √ e−v dv

π x

r − 12 σ 2

θ =

σ

92

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

√ 2

2 2e−(2x−2y+z) /2tp

= ) ×

πtp t2p−1 (tp − tp−1 )2

(1)

σ(tp−1 ,tp ) (μ(tp−1 ,tp ) (x, y, z) − x + z − 2y) −(x−μ(1) (x,y,y))2 /2σ(t

2

√ e (tp−1 ,tp ) p−1 ,tp )

2π

(1)

+ σ(t2 p−1 ,tp ) + (μ(tp−1 ,tp ) (x, y, z))2

x − μ

(1)

(x, y, z)

(1) (t ,t

p−1 p )

+μ(tp−1 ,tp ) (x, y, z)(z − 2y − 2x) − 2x(z − 2y) 1−Φ

σ(tp−1 ,tp )

*

−(2x−z)2 /2tp σ(tp−1 ,tp ) −(x−μ(tp−1 ,tp ) (x,z)) /2σ(tp−1 ,tp )

(2)

2 2 2

= × e √ e

πtp tp−1 2 2π

x − μ(2) (x, z)

(2) (t ,t

p−1 p )

+(μ(tp−1 ,tp ) (x, z) − 2x) 1 − Φ

σ(tp−1 ,tp )

2 σ(tp−1 ,tp ) −(x−μ(3) (x,z))2 /2σ(t

2

−e−z /2tp √ e (tp−1 ,tp ) p−1 ,tp )

2π

x − μ(3) (x, z)

(3) (tp−1 ,tp )

+(μ(tp−1 ,tp ) (x, z) − 2x) 1 − Φ

σ(tp−1 ,tp )

93

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

x

1 2

Φ(x) = √ e−y /2 dy

−∞ 2π

(1) 2x(tp − tp−1 ) + (2y − z)tp−1

μ(tp−1 ,tp ) (x, y, z) =

tp

(2) 2x(tp − tp−1 ) + ztp−1

μ(tp−1 ,tp ) (x, z) =

tp

(3) 2xtp − ztp−1

μ(tp−1 ,tp ) (x, z) =

tp

tp−1

σ(t2 p−1 ,tp ) = (tp − tp−1 )

tp

and,

1− 2r2

S0 eσz σ

h(tp , z) = 1 − N(d+

2 (tp , z)) + N(d−

2 (tp , z))

B

± (ln(S0 ) + σz − ln(B)) + (r − 12 σ 2 )(T − tp )

d±

2 (tp , z) =

σ T − tp

1 2 )u+σW

Proof. First, recall that since S(u) = S0 e(r− 2 σ u

, σ > 0 by assumption,

and log is an increasing function (so we can interchange the order of log and

min) we have

„ «

% & 1 2

α log minu≤tp−1 S0 e(r− 2 σ )u+σWu )

α log(minu≤tp−1 S(u))

E e = E e

% &

α(minu≤tp−1 (r− 12 )u+σWu )

= S0α E e

% cu )

&

ασ(minu≤tp−1 W

= S0α E e

94

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

1 2

r− 2 σ

σ

. Therefore, the above computation simpliﬁes to computing the moment

This formula is well known (see for instance [4]) and so we have,

% &

α log(minu≤tp−1 S(u))

E e

√ √

ασ + θ ασ(ασ+2θ)tp−1 /2 (ασ + θ) tp−1 θ −θ tp−1

= S0 α

e Erfc √ + Erfc √

ασ + 2θ 2 ασ + 2θ 2

:= S0α f (α, tp−1) (4.22)

where,

∞

2 2

Erfc(x) = √ e−v dv

π x

% &

Now, we will compute E PB,p,n

2

e−α log(minu≤tp−1 S(u)) . The general goal will

u . First, we

be to write everything in terms of expectations of functionals of W

note that

' (

PB,p,n (x) = E 1minu≤T S(u)≤B |Xp = x

+ ,

= E 1minu≤T S(u)≤B |Xp = (min S(u), S(tp ), 1τ ≤tp )

u≤tp

tp ≤u≤T

1− 2r2

S(t ) σ

N(d−

p

= 1minu≤tp S(u)≤B + 1minu≤tp S(u)>B 1 − N(d+ 2)+ 2)

B

95

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

where,

S(tp )

± ln B

+ (r − 12 σ 2 )(T − tp )

d±

2 =

σ T − tp

2 we will ﬁnd it useful to substitute the formula S(tp ) =

S0 eσWtp and write the dependence on tp and W

c

σWtp

± ln + (r − 12 σ 2 )(T − tp )

S0 e

B

d±

2 (tp , Wtp ) =

σ T − tp

± ln(S0 ) + σ Wtp − ln(B) + (r − 12 σ 2 )(T − tp )

=

σ T − tp

c

In addition, we also substitute S(u) = S0 eσWu into the expression for PB,p,n

W

p σ

+1minu≤t 1 − N(d+

p

cu >( 1 ) ln(B/S0 )

W 2 (tp , Wtp ))

σ

ctp

1− 2r2

σW σ

S0 e

+ N(d−

2 (tp , Wtp ))

B

Hence,

cu >( 1 ) ln(B/S0 ) h(tp , Wtp )

2

p W σ p W σ

96

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

where

⎛ 1− 2r2 ⎞

ctp

σW σ

tp ) = ⎝1 − N(d+ (tp , W

tp )) + S0 e ⎠

h(tp , W 2 N(d−

2 (tp , Wtp ))

B

% &

−α log(minu≤tp−1 S(u))

Hence, plugging in the expression for 2

PB,p,n into E PB,p,n e

2

we have,

% &

E PB,p,n

2

e−α log(minu≤tp−1 S(u))

% cu

&

−ασ minu≤tp−1 W

= S0−α E 1minu≤t Wcu ≤( ) ln(B/S0 )

1 e

p σ

c

+S0−α E 1minu≤t W 2 −ασ minu≤tp−1 Wu

cu >( 1 ) ln(B/S0 ) h(tp , Wtp ) e (4.23)

p σ

where the expectation above is taken with respect to the measure P for which

W

t = θdt + dWt

dW

r− 12 σ2

where Wt is a P standard Brownian motion and θ = σ

.

Using Girsanov’s theorem (see [24] or [28]), W

tion under P

97

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

+ t ,

1 t 2

Z(t) = exp − θdWu − θ du

0 2 0

+ t ,

1 2

= exp − θ(dWu − θu) − θ t

2

+ 0

,

t + 1 θ2 t

= exp −θW

2

to get

Therefore, we rewrite Equation (4.23) as an expectation under P

% &

E 2

PB,p,n e−α log(minu≤tp−1 S(u))

% cu

&

=

S0−α E 1minu≤t Wcu ≤( 1 ) ln(B/S0 ) e

−ασ minu≤tp−1 W

Z(tp ) −1

p σ

cu

1

+S0−α E

cu >( 1 ) ln(B/S0 ) h(tp , Wtp )

2 −ασ minu≤tp−1 W

e Z(tp )−1

minu≤t p W σ

% cu θ W

&

1 −ασ minu≤tp−1 W ctp − 1 θ 2 tp

= S0−α E cu ≤( 1 ) ln(B/S0 ) e

minu≤tp W e 2

σ

cu θ W

c

+S −α E 1 c 1

tp )2 e−ασ minu≤tp−1 W

h(tp , W

1 2

e tp − 2 θ tp

0 minu≤tp Wu >( σ ) ln(B/S0 )

− 12 θ 2 tp

= S0−α e 1y≤( 1 ) ln(B/S0 ) e−ασx+θz Γ(tp−1 ,tp ) (dx, dy, dz)

σ

+ 1y> 1 ln(B/S0 ) h(tp , z)2 e−ασx+θz Γ(tp−1 ,tp ) (dx, dy, dz) (4.24)

σ

where,

min W

Γ(tp−1 ,tp ) (dx, dy, dz) = P( u ∈ dx, min W tp ∈ dz)

u ∈ dy, W

u≤tp−1 u≤tp

98

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

The

u is a standard Brownian motion under P.

and as stated before, W

formula for Γ(tp−1 ,tp ) (dx, dy, dz) is given by Lemma A.0.3 in the Appendix and

is,

where,

√ 2

2 2e−(2x−2y+z) /2tp

= ) ×

πtp t2p−1 (tp − tp−1 )2

(1)

σ(tp−1 ,tp ) (μ(tp−1 ,tp ) (x, y, z) − x + z − 2y) −(x−μ(1) (x,y,y))2 /2σ(t

2

√ e (tp−1 ,tp ) p−1 ,tp )

2π

(1)

+ σ(t2 p−1 ,tp ) + (μ(tp−1 ,tp ) (x, y, z))2

(1)

x − μ(tp−1 ,tp ) (x, y, z)

(1)

+μ(tp−1 ,tp ) (x, y, z)(z − 2y − 2x) − 2x(z − 2y) 1−Φ

σ(tp−1 ,tp )

99

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

*

−(2x−z) /2tp σ(tp−1 ,tp ) −(x−μ(tp−1 ,tp ) (x,z)) /2σ(tp−1 ,tp )

(2)

2 2 2 2

= × e √ e

πtp tp−1 2 2π

x − μ(2) (x, z)

(2) (tp−1 ,tp )

+(μ(tp−1 ,tp ) (x, z) − 2x) 1 − Φ

σ(tp−1 ,tp )

2 σ(tp−1 ,tp ) −(x−μ(3) (x,z))2 /2σ(t

2

−e−z /2tp √ e (tp−1 ,tp ) p−1 ,tp )

2π

x − μ(3)

(3) (tp−1 ,tp ) (x, z)

+(μ(tp−1 ,tp ) (x, z) − 2x) 1 − Φ

σ(tp−1 ,tp )

and,

μ(tp−1 ,tp ) (x, y, z) =

tp

(2) 2x(tp − tp−1 ) + ztp−1

μ(tp−1 ,tp ) (x, z) =

tp

(3) 2xtp − ztp−1

μ(tp−1 ,tp ) (x, z) =

tp

tp−1

σ(t2 p−1 ,tp ) = (tp − tp−1 )

tp

100

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

% &

E PB,p,n

2

e−α log(minu≤tp−1 S(u))

1 2

= S0−α e− 2 θ tp 1y≤( 1 ) ln(B/S0 ) e−ασx+θz Γ(tp−1 ,tp ) (dx, dy, dz)

σ

+ 1y> 1 ln(B/S0 ) h(tp , z)2 e−ασx+θz Γ(tp−1 ,tp ) (dx, dy, dz)

σ

1 2

= S0−α e− 2 θ tp

× 1y≤( 1 ) ln(B/S0 ) e−ασx+θz Ψ(tp−1 ,tp ) (x, y, z)1y<x,y≤z,x≤0dzdydz

σ

+ 1y≤( 1 ) ln(B/S0 ) e−ασx+θz Υ(tp−1 ,tp ) (x, z)δx (dy)1y≤z,x≤0dzdx

σ

+ 1y> 1 ln(B/S0 ) h(tp , z)2 e−ασx+θz Ψ(tp−1 ,tp ) (x, y, z)1y<x,y≤z,x≤0dzdydz

σ

+ 1y> 1 ln(B/S0 ) h(tp , z)2 e−ασx+θz Υ(tp−1 ,tp ) (x, z)δx (dy)1y≤z,x≤0dzdx

σ

1 2

= S0−α e− 2 θ tp

1

( σ ) ln(B/S0 ) 0 ∞

× e−ασx+θz Ψ(tp−1 ,tp ) (x, y, z)dzdxdy

−∞ y y

( σ1 ) ln(B/S0 ) ∞

+ e−ασx+θz Υ(tp−1 ,tp ) (x, z)dzdx

−∞ x

0 0 ∞

+ h(tp , z)2 e−ασx+θz Ψ(tp−1 ,tp ) (x, y, z)dzdxdy

( σ1 ) ln(B/S0 ) y y

0 ∞

+ h(tp , z)2 e−ασx+θz Υ(tp−1 ,tp ) (x, z)dzdx

( σ1 ) ln(B/S0 ) x

(4.25)

Therefore, substituting Equations 4.22 and 4.25 and our equation for P B (0, T )

101

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

σnB (α)

n ( σ1 ) ln(B/S0 ) 0 ∞

− 12 θ 2 tp

= f (α, tp−1)e e−ασx+θz Ψ(tp−1 ,tp ) (x, y, z)dzdxdy

p=1 −∞ y y

( σ1 ) ln(B/S0 ) ∞

+ e−ασx+θz Υ(tp−1 ,tp ) (x, z)dzdx

−∞ x

0 0 ∞

+ h(tp , z)2 e−ασx+θz Ψ(tp−1 ,tp ) (x, y, z)dzdxdy

( σ1 ) ln(B/S0 ) y y

0 ∞

+ h(tp , z)2 e−ασx+θz Υ(tp−1 ,tp ) (x, z)dzdx

( σ1 ) ln(B/S0 ) x

1− 2r2 2

S0 σ

− 1 − N(d+

2 (0, 0)) + N(d−

2 (0, 0))

B

explicit (up to a multiple integrals) expression (Equation 4.21) for the vari-

ance of the IPS estimator with our particular choice of weight function. Our

weight function, Equation 4.11, puts more emphasis on the path-particles whose

Since we have an explicit formula for the variance of our IPS estimator, we

can compare the variance of performing the selection and mutation algorithm

102

Chapter 4. Credit Derivatives Pricing with Interacting Particle Systems

(1 − P B (0, T )) which is of order (P B (0, T )). The formula for P B (0, T ) is given

in Equation 4.2.

To compute the integrals appearing in Equation 4.21 and hence the vari-

However, the integrals appearing in Equation 4.21, as written, don’t have rect-

The numerical results of comparing the asymptotic variance of IPS and pure

103

Chapter 5

Results

5.1 Introduction

IPS procedure for estimating the probability mass function of the loss function

IPS performs better than traditional Monte Carlo for computing rare event

variance.

For the single name case, we compute the probability of default for diﬀerent

values of the barrier using IPS and traditional MC. In addition, for each method,

104

Chapter 5. Numerical Implementation and Results

we implemented the continuity correction for the barrier level described in [7]

to account for the fact that we using a discrete approximation to the continuous

barrier for both IPS and MC. For the diﬀerent values of the barrier we use, we

The following are the parameters we used for both IPS and MC.

α r σ S0
t T n M

-18.5 .06 .25 80 .001 1 20 20000

One can see that IPS is capturing the rare event probabilities for the single

fault probabilities but the user can see that IPS is capturing the rare events

probabilities for the single name case whereas traditional Monte Carlo is not

In Figure 5.2, we show how the variance decreases with the barrier level,

and therefore with the default probability for MC and IPS. In the IPS case, the

variance is obtained empirically and using the integral formulas derived in the

Appendix. We deduce that the variance for IPS decreases as p2 (p is the default

105

Chapter 5. Numerical Implementation and Results

MC vs IPS

0

10

2

10

IPS

4 MC

10

True Value

Probabilitiy of Default

6

10

8

10

10

10

12

10

14

10

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8

Barrier/S0

Figure 5.1: Default probabilities for diﬀerent barrier levels for IPS and MC

of the standard deviation of the estimator (whose theoretical value does depend

compare the two methods by comparing the empirical ratios of their standard

106

Chapter 5. Numerical Implementation and Results

5

10

0

10

5

10

10

10

Variance

IPS Theoretical Variance

15

10 MC Theoretical Variance

MC prob. default squared

20

10

25

10

30

10

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8

B/S0

Figure 5.2: Variances for diﬀerent barrier levels for IPS and MC

probability of default for a certain barrier level B, then the standard deviation,

P2MC (B) = P B (0, T ) × (1 − P B (0, T ))

P2MC (B) (1 − P B (0, T ))

=

P B (0, T ) P B (0, T )

107

Chapter 5. Numerical Implementation and Results

=

P B (0, T ) P B (0, T )

For both methods, we will use the theoretical formulas as well as empirically

derived quantities.

In Figure 5.3, the reader sees that there are speciﬁc regimes where it is

more eﬃcient to use IPS as opposed to traditional MC for certain values of the

barrier level. This is to be expected because IPS is well suited to rare event

108

Chapter 5. Numerical Implementation and Results

7

10

IPS Theoretical

IPS Empirical

6

10 MC Theoretical

MC Emprical

5

10

4

10

p2(x)/p(x)

3

10

2

10

1

10

0

10

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8

B/S0

5.3 Multi-Name

we took all of the ﬁrms to be homogenous, meaning that they have the same

parameters, starting value, and default barrier in equation (4.3). The following

109

Chapter 5. Numerical Implementation and Results

α r σi Si (0) Bi
t T n M

-18.5/25 .06 .3 90 36 .001 1 20 10000

The following two pictures illustrate the diﬀerence between using MC and

IPS to estimate the loss probability mass function. That is, we calculate nu-

merically,

P (L(T ) = k)

where L(T ) is the number of ﬁrms that have defaulted before time T deﬁned

in equation (6.3). Figure 5.4 shows the shape of the pmf. Here, one sees that

on the linear scale, it is hard to distinguish IPS from MC. However, Figure 5.5

is much more interesting because the pmf is on a log scale (in y) and one can

see that the IPS method is picking up more of the tail events for the pmf of

the loss function and the distinction between IPS and MC becomes clear. Also,

one can see that for this regime, MC is only good for estimating the pmf for

K = 0, 1, 2, 3, 4, but that IPS is good for estimating the pmf for K = 0, 1, . . . , 10.

Considering the fact that most contracts are written only on the ﬁrst 40% of

110

Chapter 5. Numerical Implementation and Results

losses and 10 = .4 × 25, we see that IPS does a good job of describing the rare,

0.8 MC

IPS

0.7

0.6

0.5

P(Loss = K)

0.4

0.3

0.2

0.1

0 5 10 15 20

Number of Defaults (K)

Figure 5.4: Probability mass function of the loss function described in equation

(6.3) with N = 25

111

Chapter 5. Numerical Implementation and Results

0

10

MC

IPS

2

10

4

10

P(Loss = K)

6

10

8

10

10

10

0 2 4 6 8 10

Number of Defaults (K)

Figure 5.5: Probability mass function of the loss function described in equation

(6.3) with N = 25 in log scale

112

Chapter 6

Other Applications of

Interacting Particle Systems

6.1 Introduction

in the ﬁrst passage model context. We focus on the ﬁrst passage model to

two risk management metrics that we will consider are portfolio Value-at-Risk

we consider ﬁrms behave under the ﬁrst passage model. That is, we assume

113

Chapter 6. Other Applications of Interacting Particle Systems

that the ﬁrm values for the N names have the following dynamics,

where r is the risk-free interest rate, σi is constant volatility, and the driving

correlation

d Wi , Wj t = ρij dt.

Each ﬁrm i is also assumed to have a deterministic boundary process Bi (t) and

In addition, for each ﬁrm i there corresponds the amount of notional ni that’s

written on that ﬁrm in the portfolio. This is the amount of capital that is at risk

if the ith ﬁrm defaults. The notional is assumed to be constant throughout the

as

N

L(T ) = ci 1{τi ≤T } (6.3)

i=1

where

ci = (1 − ri )ni

114

Chapter 6. Other Applications of Interacting Particle Systems

(VaR) for the above portfolio. That is, we would like to ﬁnd x.99 such that

The interpretation of x.99 is that it is the amount of money one can be sure

that the portfolio loss will not exceed with a probability of 99%.

rare-level set [x.99 , ∞) for the ﬁxed probability .01. Without explicit formulas

x.99 .

tion

The use of MC for the calculation of VaR levels is a very well developed

using traditional MC for VaR and refer the reader to [18] for a more complete

115

Chapter 6. Other Applications of Interacting Particle Systems

where the default times above were simulated by using the dynamics in

Equation (4.3) and keeping track of the default time on a path by path basis.

For each X j (T ) we form the corresponding portfolio loss for that trajectory,

N

j

L (T ) = ci 1τ j ≤T

i

i=1

1

M

1 i

M i=1 L̄ (T )≥x

116

Chapter 6. Other Applications of Interacting Particle Systems

We can reverse the idea above to ﬁnd x.99 . We set j = .01 × M and by

setting x.99 = L̄j (T ) we have that

1

M

P(L(T ) ≥ L̄j (T )) ∼ 1 i j

M i=1 L̄ (T )≥L̄ (T )

1

= .01 × M −→ .01

M

Therefore, the user sees that determining the VaR level consists in gener-

ating the independent losses, ordering them, and then picking the correct one

of Value at Risk

P(L(T ) ≥ x)

dure with a particular choice of weight function. Again, we would use the weight

function that’s given by the running minimum of the ﬁrm value. Therefore, we

117

Chapter 6. Other Applications of Interacting Particle Systems

where

N

V (Xp ) = log(min Si (u))

u≤tp

i=1

Then, we run the mutation and selection algorithm with the weight function

above until time T . Then, we know that the unbiased estimator for P(L(T ) ≥ x)

is given by

n−1

1

M

1Li (T )≥x exp(−α(V (Ŵn(i) ) − V0 )) × η̂pM (6.5)

M i=1 p=1

Let,

n−1

ki = exp(−α(V (Ŵn(i) ) − V0 )) × η̂pM

p=1

Therefore, the IPS estimator can be written in the more compact version,

1

M

ki 1Li (T )≥x

M i=1

Now, for each Li (T ) we have the corresponding weight ki. Given the set

(Li (T ), ki )1≤i≤M , we denote the reverse order statistics of Li (T ) and its corre-

1

M

k̄i 1L̄i (T )≥x

M i=1

118

Chapter 6. Other Applications of Interacting Particle Systems

Now, to determine the VaR level we do the following. We form the vector

i

ji = k̄p

p=1

and set

Then, our IPS estimate of VaR is x.99 = L̄j (T ).

1 1

M

k̄i 1L̄i (T )≥L̄j (T ) = k̄1 + k̄2 + · · · + k̄j −→ .01

M i=1 M

E(L(T )|L(T ) ≥ a)

The a above may come from a VaR type analysis (i.e. a = x.99 ) or diﬀerent

119

Chapter 6. Other Applications of Interacting Particle Systems

M

L̄i (T ) and let j = i=1 1L̄i (T )≥a . Then the unbiased estimator for the above

conditional expectation is

1

M

Li (T )1Li (T )≥a

E(L(T )|L(T ) ≥ a) ∼ M

1

i=1

M

M i=1 1Li (T )≥a

1

M i

M i=1 L̄ (T )1L̄i (T )≥a

= 1

M

M i=1 1L̄i (T )≥a

1 i

M

= L̄ (T )1L̄i (T )≥a

j i=1

j

1 i

= L̄ (T )

j i=1

by the deﬁnition of j and the way we calculate VaR levels. Therefore, only 100

trajectories are used for our estimate, which results in a very large variance.

This problem is only exacerbated for even higher level of a’s. This problem is

must investigate the behavior of the density in the tail. However, in using MC

simulations, reaching the tail of the distribution is itself very diﬃcult, let alone

120

Chapter 6. Other Applications of Interacting Particle Systems

One of the main culprits of the above shortcomings with using MC to es-

probability of the rare event and the number of MC trajectories that exceed the

rare event. However, IPS doesn’t suﬀer from this problem because it twists the

empirical distribution of the particles so that more trajectories are in the tail.

Shortfall Contributions

IPS is well developed for answering questions about the conditional proba-

bilities of rare event regions. Del Moral and Garnier included the formulation

Looking at the way L(T ) is deﬁned, we can see that we want to put more

emphasis on the trajectories that see more defaults. In this way, we will be

looking at the tail events of L(T ), i.e. the regions where the portfolio loss is the

greatest. Therefore, we will use the same weight function that we have always

used.

γn (fn ) = E f (Yn ) Gk (Yk ) (6.6)

1≤k<n

121

Chapter 6. Other Applications of Interacting Particle Systems

E f (Yn ) 1≤k<n Gk (Yk )

ηn (fn ) = = γn (fn )/γn (1) (6.7)

E 1≤k<n Gk (Yk )

The Markov process for our set up is the one we introduced earlier. That is,

our Markov process is the 3 × N dimensional process (X̃t )t∈[0,T ] deﬁned as:

X̃t = (S1 (t), min S1 (u), 1τ1 ≤t , S2 (t), min S2 (u), 1τ2 ≤t , · · ·

u≤t u≤t

u≤t

We introduce the chain (Xp )0≤p≤n = (X̃pT /n )0≤p≤n and the whole history of the

N

In addition, we can easily see that L(T ) is bounded by i=1 ci which we

assume is ﬁnite. Then the rare event {L(T ) ≥ a} has the following Feynman-

Kac representation

where,

Ina (1)(y) = Ina (x0 , x1 , . . . , xn ) = 1L(T )≥a G−

p (x0 , x1 , . . . , xp )

1≤p<n

In fact, we can say something a little more general as well. Given any

122

Chapter 6. Other Applications of Interacting Particle Systems

where,

Ina (φn )(x0 , x1 , . . . , xn ) = φn (x0 , . . . , xn )1L(T )≥a G−

p (x0 , x1 , . . . , xp )

1≤p<n

Recall that

n

γn+1(1) = γn (Gn ) = ηn (Gn )γn (1) = ηp (Gp )

p=1

γn (fn ) = ηn (fn ) ηp (Gp )

1≤p<n

P(L(T ) ≥ a) = ηn (Ina (1)) ηp (Gp )

1≤p<n

E(φn (X0 , . . . , Xn ); L(T ) ≥ a) = ηn (Ina (φn )) ηp (Gp )

1≤p<n

where

123

Chapter 6. Other Applications of Interacting Particle Systems

Ina (L(T ))(x0 , . . . , xn ) = L(T )1L(T )≥a G−

p (x0 , . . . , xp )

1≤p<n

ηnM (Ina (φn ))/ηnM (Ina (1)) −→ ηn (Ina (φn ))/ηn (Ina (1)) = E(φn (X0 , . . . , Xn )|L(T ) ≥ a)

In fact, using Theorem 2.2 in Del Moral and Garnier, we have the following

theorem,

N

Theorem 6.6. Given that L(T ) = i=1 ci 1τi ≤T , the estimator ηnM (Ina (L(T )))/ηnM (Ina (1))

√

M ηnM (Ina (L(T )))/ηnM (Ina (1)) − E(L(T )|L(T ) ≥ a) −→ N(0, σn (a, L(T ))2 )

n

−2

σn (a, L(T )) = P(L(T ) ≥ a)

2

γp (1)γp− (1)ηp− (Pp,n (a, L(T ))2 )

p=1

124

Chapter 6. Other Applications of Interacting Particle Systems

Assume that we have followed the algorithm for IPS on the Markov chain

where

X̃t = (S1 (t), min S1 (u), 1τ1 ≤t , S2 (t), min S2 (u), 1τ2 ≤t , · · ·

u≤t u≤t

u≤t

Assume that we are at time T. Then we have the M simulated values for

the chain XT denoted by XTi , 1 ≤ i ≤ M. Again, we form the portfolio loss for

N

i

L (T ) = cj 1τji ≤T

j=1

M (i)

1

M i=1 Li (T )1Li (T )≥a exp(−α(V (Ŵn ) − V0 ))

= M (i)

1

M

1Li (T )≥a exp(−α(V (Ŵn ) − V0 ))

i=1

M i ˆ (i)

i=1 L̄ (T )1L̄i (T )≥a exp(−α(V (W̄n ) − V0 ))

1

M

=

1

M ˆ n(i) ) − V ))

M

1 i

i=1 exp(−α(V (W̄

L̄ (T )≥a 0

125

Chapter 6. Other Applications of Interacting Particle Systems

have that

1

M ˆ n(i) ) − V ))

M

L̄i (T )1L̄i (T )≥a exp(−α(V (W̄

i=1 0

M ˆ (i)

i=1 1L̄i (T )≥a exp(−α(V (W̄n ) − V0 ))

1

M

j i ˆ (i)

i=1 L̄ (T )1L̄i (T )≥a exp(−α(V (W̄n ) − V0 ))

= j ˆ n(i) ) − V ))

1 i

i=1 exp(−α(V (W̄

L̄ (T )≥a 0

j

= L̄i (T )pi1L̄i (T )≥a

i=1

j

ηnM (Ina (L(T )))/ηnM (Ina (1)) = L̄i (T )pi (6.8)

i=1

where

ˆ n(i) ) − V ))

exp(−α(V (W̄ 0

pi = j , 1 ≤ i ≤ j

exp(−α(V ( ˆ n ) − V ))

W̄

(k)

k=1 0

and

j

pi = 1

i=1

1 i

j

ηnM (Ina (L(T )))/ηnM (Ina (1)) = L̄ (T )bi (6.9)

j i=1

where

bi = pi j

126

Chapter 6. Other Applications of Interacting Particle Systems

6.6.2 Remarks

Equation (6.9) is more like the equations you would see with traditional MC.

However, the important items to be noted here are the normalizing constants

bi that don’t appear in traditional MC, and the fact that j is determined in

M i.i.d samples, only P(L(T ) ≥ a) × M will be in the rare level set [a, ∞).

This is precisely because all of the samples are i.i.d. and come from the original

distribution, for which it is diﬃcult to simulate the tail. However, IPS is quite

diﬀerent.

Recall that even though IPS is performed under the original measure, the

127

Chapter 6. Other Applications of Interacting Particle Systems

where,

i

ji = k̄p

p=1

n−1

ˆ (i) ) − V )) ×

k̄i = exp(−α(V (W̄ η̂pM

n 0

p=1

for IPS to handle and we would expect that the number of particles that exceed

close to M. One can see that this could potentially have a profound impact.

r σ S0
t T n M

.06 .3 90 .001 1 10 10000

128

Chapter 6. Other Applications of Interacting Particle Systems

Then we compute the estimates for E(L(T )|L(T ) ≥ a) for a ∈ {0, 1000, 2000, . . . , 10000}.

In the graph below we display the results. The estimates for MC go to zero (af-

ter a certain a) because none of the simulated trajectories entered that rare

event region.

The most interesting thing to look at is the j value for MC and IPS for all

a Monte Carlo j IPS j

0 10000 10000

1000 1154 9598

2000 307 9034

3000 93 8392

4000 34 7548

5000 14 6612

6000 3 5644

7000 2 4634

8000 1 3548

9000 0 2371

10000 0 1241

The above table shows the substantial improvement one can expect in using

IPS for expected shortfall versus MC. Note that the number of trajectories for

129

Chapter 6. Other Applications of Interacting Particle Systems

12000

IPS

MC

10000

8000

E(L(T) | L(T) a)

6000

4000

2000

0

0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000

a

IPS that yield a loss of 10,000 (the maximum) is 1241, where as the number

of trajectories for MC that exceed a loss of 1,000 is only 1154. While these

numbers will change from simulation run to simulation run, they do give one a

Next, we look at a particular case were defaults are more rare. Here we take

130

Chapter 6. Other Applications of Interacting Particle Systems

12000

10000

8000

E(L(T) | L(T) a)

6000

4000

2000

0

0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000

a

Probabilities

131

Chapter 6. Other Applications of Interacting Particle Systems

0 10000 10000

1000 129 7904

2000 11 6417

3000 2 5076

4000 1 3993

5000 0 2974

6000 0 2205

7000 0 1509

8000 0 946

9000 0 514

10000 0 193

region for estimating expected shortfall. That is, there are very few trajectories

that exceed the rare event for the calculation of the expected shortfall. However,

one can see that IPS pushes more of the trajectories into the tail so that there

are more simulated paths in the rare event region to compute the expected

shortfall with more accuracy. Though these j numbers will change with each

132

Chapter 7

Conclusion

of rare event probabilities to the ﬁeld of credit risk under the ﬁrst passage model.

We showed that with our choice of weight function, IPS is more eﬃcient than

risk. We derived an explicit formula for the asymptotic variance of applying IPS

using our particular choice of weight function. We showed that applying IPS to

for the following reasons. First, IPS doesn’t require the user to compute a change

dynamically consistent in time which allows the user to use the same simulation

133

Chapter 7. Conclusion

In addition, we showed that there are speciﬁc regimes where IPS is much

better suited to credit risk than traditional MC methods. We also started the

Our future research will be to adapt our algorithm to more complicated mod-

els that incorporate more realistic market structures such as stochastic volatility

134

Appendix A

Proofs

1 −(|z−y|−y)2 /2t

P( min Ws ≤ y, Wt ∈ dz) = √ e 1y≤0 dz (A.1)

0≤s≤t 2πt

0≤s≤t

1

2 −(z−2y)2 /2t

= (z − 2y)e 1y≤z,y≤0 dzdy (A.2)

πt3

Lemma A.0.1. Let Wt be a standard Brownian motion and tp−1 < tp . Let

g(a,c,tp−1 ) (db, de, tp ) = P(min Wu ∈ db, Wtp ∈ de| min Wu ∈ da, Wtp−1 ∈ dc)1a≤c,a≤0

u≤tp u≤tp−1

Then,

135

Appendix A. Proofs

*

2 2

= (e + c − 2b)e−(e+c−2b) /2(tp −tp−1 ) dbde1b<a,b≤e,b≤0,a≤c,a≤0

π(tp − tp−1 ) 3

1

−(c−e)2 /2(tp −tp−1 ) −(e+c−2a)2 /2(tp −tp−1 )

+ e −e de1a≤e,a≤c,a≤0 δa (db)

2π(tp − tp−1 )

136

Appendix A. Proofs

Proof.

u≤tp u≤tp−1

= P(min( min Wu , min Wu ) ∈ db, Wtp ∈ de| min Wu ∈ da, Wtp−1 ∈ dc)1a≤c,a≤0

u≤tp−1 tp−1 <u≤tp u≤tp−1

tp−1 <u≤tp u≤tp−1

tp−1 <u≤tp u≤tp−1

tp−1 <u≤tp

∞

+ P( min Wu ∈ dx, Wtp ∈ de|Wtp−1 ∈ dc)1a≤c,a≤0 δa (db)

a tp−1 <u≤tp

u≤tp −tp−1

∞

+ P((c + min Wu ) ∈ dx, (c + Wtp −tp−1 ) ∈ de)1a≤c,a≤0 δa (db)

u≤tp −tp−1

a

∞

= φtp −tp−1 (b − c, e − c)dbde1b<a + φtp −tp−1 (x − c, e − c)dx de1a≤c,a≤0 δa (db)

a

*

∞

2 2

+ (e + c − 2x)e−(e+c−2x) /2(tp −tp−1 ) 1x≤e,x≤cdx de1a≤c,a≤0 δa (db)

a π(t p − tp−1 ) 3

*

min(e,c)

2 2

+ (e + c − 2x)e−(e+c−2x) /2(tp −tp−1 ) dx de1a≤c,a≤0 δa (db)

a π(tp − tp−1 ) 3

1

−(c−e)2 /2(tp −tp−1 ) −(e+c−2a)2 /2(tp −tp−1 )

+ e −e de1e≤c,a≤c,a≤0δa (db)

2π(tp − tp−1 )

1 2 2

+ e−(e−c) /2(tp −tp−1 ) − e−(e+c−2a) /2(tp −tp−1 ) de1c≤e,a≤c,a≤0δa (db)

2π(tp − tp−1 )

*

2 2

= (e + c − 2b)e−(e+c−2b) /2(tp −tp−1 ) dbde1b<a,b≤e,a≤c,a≤0

π(tp − tp−1 ) 3

137

1

−(c−e)2 /2(tp −tp−1 ) −(e+c−2a)2 /2(tp −tp−1 )

+ e −e de1a≤e,a≤c,a≤0 δa (db)

2π(tp − tp−1 )

Appendix A. Proofs

Lemma A.0.2. Let Wt be a standard Brownian motion and tp−1 < tp . Let

Φ(tp−1 ,tp ) (da, db, dc, de) denote the following density,

Φ(tp−1 ,tp ) (da, db, dc, de) = P min Wu ∈ da, min Wu ∈ db, Wtp−1 ∈ dc, Wtp ∈ de

u≤tp−1 u≤tp

Then,

*

2 2

= (e + c − 2b)e−(e+c−2b) /2(tp −tp−1 ) dbde1b<a,b≤e

π(tp − tp−1 ) 3

1

−(c−e)2 /2(tp −tp−1 ) −(e+c−2a)2 /2(tp −tp−1 )

+ e −e de1a≤e δa (db)

2π(tp − tp−1 )

*

2 2 /2t

× 3 (c − 2a)e−(c−2a) p−1

1a≤c,a≤0 dadc

πtp−1

Proof.

= P min Wu ∈ da, min Wu ∈ db, Wtp−1 ∈ dc, Wtp ∈ de

u≤tp−1 u≤tp

= P(min Wu ∈ db, Wtp ∈ de| min Wu ∈ da, Wtp−1 ∈ dc) × P( min Wu ∈ da, Wtp−1 ∈ dc)

u≤tp u≤tp−1 u≤tp−1

Substitute the equations for g(a,c,tp−1 ) (db, de, tp ) (Lemma A.0.1) and φtp−1 (a, c)dadc

138

Appendix A. Proofs

Lemma A.0.3. Let Wt be a standard Brownian motion and tp−1 < tp . Let

Γ(tp−1 ,tp ) (da, db, de) = P( min Wt ∈ da, min Wt ∈ db, Wtp ∈ de)

t≤tp−1 t≤tp

Then,

Γ(tp−1 ,tp ) (da, db, de) = Ψ(tp−1 ,tp ) (a, b, e)1b<a,b≤e,a≤0 dedbda

(A.3)

where,

√ 2

2 2e−(2a−2b+e) /2tp σ(μ(1) − a + e − 2b) −(a−μ(1) )2 /2σ2

= ) × √ e

πtp t2p−1 (tp − tp−1 )2 2π

2 a − μ (1)

+ σ + (μ(1) )2 + μ(1) (e − 2b − 2a) − 2a(e − 2b) 1 − Φ( )

σ

139

Appendix A. Proofs

*

2 −(2a−e)2 /2tp σ −(a−μ(2) )2 /2σ2 a − μ(2)

= e √ e + (μ − 2a)(1 − Φ(

(2)

)

πtp tp−1 2 2π σ

−e2 /2tp σ −(a−μ(3) )2 /2σ2 a − μ(3)

−e √ e + (μ − 2a)(1 − Φ(

(3)

)

2π σ

and,

μ(1) =

tp

2a(tp − tp−1 ) + etp−1

μ(2) =

tp

2atp − etp−1

μ(3) =

tp

tp−1

σ2 = (tp − tp−1 )

tp

Proof. Our strategy is to integrate the four-dimensional distribution Φ(tp−1 ,tp ) (da, db, dc, de)

that we found in Lemma A.0.2 with respect to c. That is, we calculate explicitly,

∞

Γ(tp−1 ,tp ) (da, db, de) = Φ(tp−1 ,tp ) (da, db, dc, de)

−∞

where the integral above is taken with respect to c. Recall that the formula

for Φ(tp−1 ,tp ) (da, db, dc, de) is separated into two distinct regions; either b < a

140

Appendix A. Proofs

or b = a. Therefore, to integrate Φ(tp−1 ,tp ) (da, db, dc, de) we will deal with each

region separately.

Φ(tp−1 ,tp ) (da, db, dc, de) = f (a, b, c, e)dedcdbda + χ(a, c, e)δa (db)dedcda

where,

f (a, b, c, e)

2 2 /2t 2

= ) (c − 2a)(e − 2b + c)e−(c−2a) p−1 −(e−2b+c) /2(tp −tp−1 )

1b<a,b≤e,a≤c,a≤0

π 2 t3p−1 (tp − tp−1 )3

and,

χ(a, c, e)

(c − 2a)e−(c−2a) /2tp−1 −(c−e)2 /2(tp −tp−1 )

2

−(e+c−2a)2 /2(tp −tp−1 )

= e −e 1a≤e,a≤c,a≤0

π 2 tp−1 3 (tp − tp−1 )

Therefore,

∞ ∞

Γ(tp−1 ,tp ) (da, db, de) = f (a, b, c, e)dc dedbda+ χ(a, b, c, e)δa (db)dc deda

−∞ −∞

141

Appendix A. Proofs

∞

We ﬁrst compute −∞

f (a, b, c, e)dc.

write f as,

2

2e−(2a−2b+e) /2tp (1) 2 2

f (a, b, c, e) = ) (c2 +c(e−2b−2a)−2a(e−2b))e−(c−μ ) /2σ 1b<a,b≤e,a≤c,a≤0

π 2 t3p−1 (tp − tp−1 )3

where,

μ(1) =

tp

tp−1

σ2 = (tp − tp−1 )

tp

We must calculate

∞

:= f (a, b, c, e)dc

−∞

∞ 2

2e−(2a−2b+e) /2tp (1) 2 2

= ) (c2 + c(e − 2b − 2a) − 2a(e − 2b))e−(c−μ ) /2σ 1b<a,b≤e,a≤0 dc

a π 2 t3p−1 (tp − tp−1 )3

−(2a−2b+e)2 /2tp

Let A = √2e 2 3 . We drop the indicator function 1b<a,b≤e,a≤0 for

π tp−1 (tp −tp−1 )3

142

Appendix A. Proofs

√ ∞

1 (1) )2 /2σ 2

= A 2πσ 2 √ (c2 + c(e − 2b − 2a) − 2a(e − 2b))e−(c−μ dc

a 2πσ 2

(1)

Make the change of variable x = c−μσ

√ ∞

1

−x2 /2

= A 2πσ 2 √ (σx + μ (1) 2

) + (σx + μ (1)

)(e − 2b − 2a) − 2a(e − 2b) e dx

a−μ(1) 2π

σ

Let

h(a, b, e)

∞

1

−x2 /2

= √ (σx + μ (1) 2

) + (σx + μ (1)

)(e − 2b − 2a) − 2a(e − 2b) e dx

a−μ(1) 2π

σ

so that

√

Ψ(tp−1 ,tp ) (a, b, e) = A 2πσ 2 h(a, b, e)

Therefore, we have

143

Appendix A. Proofs

h(a, b, e)

∞

1

2 2 2

= (1)

√ σ x + xσ(e − 2b − 2a + 2μ(1) ) e−x /2 dx

a−μ 2π

σ ∞

1 2

+ √ ((μ(1) )2 + μ(e − 2b − 2a) − 2a(e − 2b))e−x /2 dx

a−μ(1) 2π

σ

∞

σ2 2 2

= √ −xe−x /2 |∞ a−μ(1) + (1)

e−x /2 dx

2π x= σ

a−μ

∞ σ

1 −x2 /2

+σ(e − 2b − 2a + 2μ(1) ) √ xe dx

a−μ(1) 2π

σ

∞

1 2

+((μ ) + μ (e − 2b − 2a) + 2a(e − 2b))

(1) 2 (1)

(1)

√ e−x /2 dx

a−μ

σ

2π

σ(a − μ(1) ) −(a−μ(1) )2 /2σ2 a − μ(1)

= √ e + σ 2 (1 − Φ( ))

2π σ

σ(e − 2b − 2a + 2μ(1) ) −(a−μ(1) )2 /2σ2

+ √ e

2π

a − μ(1)

+((μ(1) )2 + μ(1) (e − 2b − 2a) − 2a(e − 2b))(1 − Φ( ))

σ

σ(μ(1) − a + e − 2b) −(a−μ(1) )2 /2σ2

= √ e

2π

a − μ(1)

+(σ 2 + (μ(1) )2 + μ(1) (e − 2b − 2a) − 2a(e − 2b))(1 − Φ( ))

σ

Since

√ −(2a−2b+e)2 /2t

√ 2 2e p

A 2πσ 2 = )

πtp t2p−1 (tp − tp−1 )2

144

Appendix A. Proofs

∞

= f (a, b, c, e)dc

−∞

√

= A 2πσ 2 h(a, b, e)

√ 2

2 2e−(2a−2b+e) /2tp σ(μ(1) − a + e − 2b) −(a−μ(1) )2 /2σ2

= ) × √ e

πtp t2p−1 (tp − tp−1 )2 2π

a−μ (1)

+(σ 2 + (μ(1) )2 + μ(1) (e − 2b − 2a) − 2a(e − 2b))(1 − Φ( )) 1b<a,b≤e,a≤0

σ

(A.4)

where for the last line above we recall the indicator function 1b<a,b≤e,a≤0 that

∞

We now calculate Υ(tp−1 ,tp ) (a, e)1a≤e,a≤0 δa (db) := −∞

χ(a, c, e)δa (db)dc. Re-

call that,

χ(a, c, e)

(c − 2a)e−(c−2a) /2tp−1 −(c−e)2 /2(tp −tp−1 )

2

−(e+c−2a)2 /2(tp −tp−1 )

= e −e 1a≤e,a≤c,a≤0

π 2 tp−1 3 (tp − tp−1 )

perform the multiplication above and separate the two terms. Completing the

145

Appendix A. Proofs

2

(c − 2a)e−(c−2a) /2tp−1 −(c−e)2 /2(tp −tp−1 ) (c − 2a) 2 (2) 2 2

e = e−(2a−e) /2tp e−(c−μ ) /2σ

π tp−1 (tp − tp−1 )

2 3

π (tp − tp−1 )tp−1

2 3

and,

2

(c − 2a)e−(c−2a) /2tp−1 −(e+c−2a)2 /2(tp −tp−1 ) (c − 2a) −e2 /2tp −(c−μ(3) )2 /2σ2

e = e e

π 2 (tp − tp−1 )tp−1 3 π 2 (tp − tp−1 )tp−1 3

where,

μ(2) =

tp

2atp − etp−1

μ(3) =

tp

and σ 2 is as before.

∞

(c − 2a) −(2a−e)2 /2tp −(c−μ(2) )2 /2σ2

e e dc

a π 2 (tp − tp−1 )tp−1 3

*

2 −(2a−e)2 /2tp σ −(a−μ(2) )2 /2σ2 a − μ(2)

= e √ e + (μ − 2a)(1 − Φ(

(2)

)

πtp tp−1 2 2π σ

c−μ(2)

after making the change of variables x = σ

146

Appendix A. Proofs

∞

(c − 2a) 2 /2t (3) )2 /2σ 2

e−e p

e−(c−μ

dc

a π 2 (tp − tp−1 )tp−1 3

*

2 −e2 /2tp σ −(a−μ(3) )2 /2σ2 a − μ(3)

= e √ e + (μ − 2a)(1 − Φ(

(3)

)

πtp tp−1 2 2π σ

c−μ(3)

after making the change of variables x = σ

∞

= χ(a, c, e)δa (db)dc

−∞

∞

(c − 2a) 2 (2) 2 2

= e−(2a−e) /2tp e−(c−μ ) /2σ dcδa (b)1b≤e,a≤0

a π 2 (tp − tp−1 )tp−1 3

∞

(c − 2a) 2 (3) 2 2

− e−e /2tp e−(c−μ ) /2σ dcδa (b)1b≤e,a≤0

a π (tp − tp−1 )tp−1

2 3

*

2 −(2a−e)2 /2tp σ −(a−μ(2) )2 /2σ2 a − μ(2)

= e √ e + (μ − 2a)(1 − Φ(

(2)

)

πtp tp−1 2 2π σ

2 σ (3) 2 2 a − μ (3)

−e−e /2tp √ e−(a−μ ) /2σ + (μ(3) − 2a)(1 − Φ( ) 1b≤e,a≤0 δa (db)

2π σ

(A.5)

147

Bibliography

form models in credit risk, in WSC ’06: Proceedings of the 38th conference

[5] D. Brigo and M. Tarenghi, Credit default swap calibration and equity

www.defaultrisk.com, (2005).

148

Bibliography

[14] D. Duffie and D. Lando, Term structures of credit spreads with incom-

able at http://ideas.repec.org/a/ecm/emetrp/v69y2001i3p633-64.html.

149

Bibliography

[15] A. Elizalde, Credit risk models iv: Understanding and pricing cdos, work-

pp. 499–544.

Springer, 2003.

[20] P. Glasserman and J. Li, Importance sampling for portfolio credit risk,

[22] , Valuing credit default swaps ii: Modeling default correlation, Journal

of Derivatives, 8 (2001).

150

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