A three-point turn in derivative design - Risk.net https://www.risk.net/our-take/7956872/a-three-point-turn-in-derivative-...

A three-point turn in derivative

design
Citibank quant’s triangle method allows information geometry to be applied to
hedge structuring

Mauro Cesa
06 Jun 2023

The artwork for Pink Floyd’s The Dark Side of the Moon is every bit as
celebrated as the album’s music. A design classic, it depicts a white beam
shining on to a glass triangle before diffracting into the constituent
colours of the spectrum.

Now Andrei Soklakov, the Asia-Pacific head of prime and delta-one

quantitative analytics at Citibank in Hong Kong, has come up with what
he hopes will be his own design classic. And, like the cover of Floyd’s
magnum
magnum opus it has a triangle at its core.
magnum opus
opus,

In 2008, Soklakov introduced the concept of information

information
information derivatives
derivatives,
derivatives
with which he intended to improve the design of volatility products by
helping structurers customise the exposure to volatility risk. It became
apparent to him that all types of derivative could benefit from a similarly
flexible design approach.

Although the work he published over the following years concerned the
design of investment
investment products Soklakov has now extended his theory to
investment products
products,
include hedging products. In his latest paper, Information
Information
Information geometry
geometry
geometry of
of
of
risks
risks
risks and
and returns he shows how derivatives can be viewed through a new
and returns
returns,
perspective and portrays their risk structure as a triangle.

In his derivatives structuring framework, information is the product’s

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underlying asset and takes the

form of probability distributions. A
product’s value will depend on the As I see it, finance is all about
difference between the probability
optimal resource allocation.
Information derivatives can be
distribution implied by the market
viewed as the result of optimal
and the probability distribution
resource allocation within the
built on the investor’s view. In the
scope of a single product
case of hedging products, a
Andrei Soklakov, Citibank
scenario distribution that
comprises market risk factors enters the picture. These three
distributions are identified by three points in a multidimensional space
and those three points form a triangle.

The co-ordinates of the three points hold the information about the three
probability distributions, and each co-ordinate corresponds to a statistic.
They might indicate the average, the volatility or the parameters of the
implied volatility surface. Those points are, in a more algebraic sense,
vectors of information.

Such representation is useful because it can be dealt with by applying

information geometry, a branch of mathematics developed to analyse
probability distributions and their relationships – for example, by
measuring their distance.

Handling all the information required to design a product in a simple

triangle facilitates the design and, according to Soklakov, allows for an
optimal allocation of resources while adhering to the investor’s views.
“As I see it, finance is all about optimal resource allocation,” he says.
“Information derivatives can be viewed as the result of optimal resource
allocation within the scope of a single product.”

And all that you deal…

“It’s an intriguing work,” says Francois Buet-Golfouse, head of decision
science at JPMorgan Chase’s UK consumer business. “Not many people

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have tried to connect information geometry and quant finance. The

difficult part is identifying the correct payoff structure, conditional to the
client’s needs and preferences. But once one has it, this approach allows
us to work out a derivative structure that replicates it.”

A client might, for example, express a positive view on a particular asset

and believe that volatility will decrease. It therefore wants a long position
on the asset and a short position on volatility. This client might also be a
pension fund that is required to limit its exposure by adding a capital
protection feature to the structure. The first idea a structurer would
typically come up with in such a case would be a call option. However,
this type of option would be long volatility, while the client would want
to be short volatility.

Soklakov’s framework enables a structurer to build a hypothetical

product based, in part, on the client’s view, but also incorporating the
market view as derived from observable data. The framework provides
the tools to combine the three probability distributions and translate into
a payoff function that includes the client’s requirements. In the example
above, the payoff function would be replicated with a basket of vanilla
calls and puts, which could be bundled into a single product.

“This theory becomes especially useful when clients want to combine

various types of views,” says Soklakov. “Combining such views optimally
in a single product is very easy within this theory.”

Because the structurer can measure the distance between distributions,

including those that are model-generated, Soklakov says the framework
enables model risk to be quantified in an easy and intuitive way, such
that the assessment of model risk can be automated and monitored.

The framework’s intuitive advantages go beyond the tractability of the

geometric representation. It translates risk in terms of returns, which
Soklakov reckons are easier to understand. “This is certainly true about
model risk and might even help with standard sensitivities,” he says.

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“Within the paper there’s a formula that helps [in] expressing risks like
delta and vega
delta
delta vega as simple spreads in expected returns.”
vega

With regard to the immediate implementation of Soklakov’s framework,

Buet-Golfouse is cautiously optimistic. “This new framework has some of
the right ingredients to become popular,” he says, “although it’s still
early days and we are still at the proof-of-concept phase.”

Soklakov himself is confident that time will prove him right. “In the
space of ideas, information derivatives are probably a niche topic,” he
says. “But in the space of financial solutions, this will be a very useful
tool. It is guaranteed to be useful.”

To assist with that, he wants to adapt his framework so it can be plugged

into existing systems. “I’m planning to write another paper showing how
to use the approach for making small improvements in existing products
as opposed to replacing them outright with brand new designs. This
could open a safer evolutionary approach of incremental improvements
in product design.”

Time will tell whether the framework has the staying power of a classic
Time
Time
album cover or whether it might even eclipse
eclipse standard approaches to
eclipse
structuring.

Editing by Daniel Blackburn

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