Objective Binomial Model What is and what is not mortgage insurance in Mexico? 3 times model (Black and Scholes) Correlated brownian motion Other

Similar documents
Change of Measure (Cameron-Martin-Girsanov Theorem)

MFIN 7003 Module 2. Mathematical Techniques in Finance. Sessions B&C: Oct 12, 2015 Nov 28, 2015

Institute of Actuaries of India. Subject. ST6 Finance and Investment B. For 2018 Examinationspecialist Technical B. Syllabus

We discussed last time how the Girsanov theorem allows us to reweight probability measures to change the drift in an SDE.

Lecture 17. The model is parametrized by the time period, δt, and three fixed constant parameters, v, σ and the riskless rate r.

Interest Rate Modeling

Risk-Neutral Valuation

Subject CT8 Financial Economics Core Technical Syllabus

1.1 Basic Financial Derivatives: Forward Contracts and Options

From Discrete Time to Continuous Time Modeling

by Kian Guan Lim Professor of Finance Head, Quantitative Finance Unit Singapore Management University

Fundamentals of Stochastic Filtering

Financial Engineering MRM 8610 Spring 2015 (CRN 12477) Instructor Information. Class Information. Catalog Description. Textbooks

THE USE OF NUMERAIRES IN MULTI-DIMENSIONAL BLACK- SCHOLES PARTIAL DIFFERENTIAL EQUATIONS. Hyong-chol O *, Yong-hwa Ro **, Ning Wan*** 1.

INTRODUCTION TO THE ECONOMICS AND MATHEMATICS OF FINANCIAL MARKETS. Jakša Cvitanić and Fernando Zapatero

Option Pricing under Delay Geometric Brownian Motion with Regime Switching

INSTITUTE OF ACTUARIES OF INDIA

Stochastic Processes and Stochastic Calculus - 9 Complete and Incomplete Market Models

Martingale Approach to Pricing and Hedging

Bluff Your Way Through Black-Scholes

Computational Finance. Computational Finance p. 1

1. 2 marks each True/False: briefly explain (no formal proofs/derivations are required for full mark).

The Merton Model. A Structural Approach to Default Prediction. Agenda. Idea. Merton Model. The iterative approach. Example: Enron

AMH4 - ADVANCED OPTION PRICING. Contents

Risk Neutral Valuation

Financial and Actuarial Mathematics

The discounted portfolio value of a selffinancing strategy in discrete time was given by. δ tj 1 (s tj s tj 1 ) (9.1) j=1

Continuous Processes. Brownian motion Stochastic calculus Ito calculus

Application of Stochastic Calculus to Price a Quanto Spread

Equivalence between Semimartingales and Itô Processes

Brownian Motion and Ito s Lemma

Risk Neutral Pricing Black-Scholes Formula Lecture 19. Dr. Vasily Strela (Morgan Stanley and MIT)

Arbitrage, Martingales, and Pricing Kernels

1 The continuous time limit

Pricing Options with Mathematical Models

STOCHASTIC CALCULUS AND DIFFERENTIAL EQUATIONS FOR PHYSICS AND FINANCE

Handbook of Financial Risk Management

Curriculum. Written by Administrator Sunday, 03 February :33 - Last Updated Friday, 28 June :10 1 / 10

FE501 Stochastic Calculus for Finance 1.5:0:1.5

and K = 10 The volatility a in our model describes the amount of random noise in the stock price. Y{x,t) = -J-{t,x) = xy/t- t<pn{d+{t-t,x))

Math 416/516: Stochastic Simulation

SYLLABUS. IEOR E4728 Topics in Quantitative Finance: Inflation Derivatives

The Black-Scholes Model

Module 10:Application of stochastic processes in areas like finance Lecture 36:Black-Scholes Model. Stochastic Differential Equation.

Option Pricing Formula for Fuzzy Financial Market

MASSACHUSETTS INSTITUTE OF TECHNOLOGY 6.265/15.070J Fall 2013 Lecture 19 11/20/2013. Applications of Ito calculus to finance

Lecture 8: The Black-Scholes theory

MSc Financial Mathematics

Randomness and Fractals

MASM006 UNIVERSITY OF EXETER SCHOOL OF ENGINEERING, COMPUTER SCIENCE AND MATHEMATICS MATHEMATICAL SCIENCES FINANCIAL MATHEMATICS.

MSc Financial Mathematics

************* with µ, σ, and r all constant. We are also interested in more sophisticated models, such as:

2 f. f t S 2. Delta measures the sensitivityof the portfolio value to changes in the price of the underlying

Lecture Notes for Chapter 6. 1 Prototype model: a one-step binomial tree

Futures Options. The underlying of a futures option is a futures contract.

Mathematics in Finance

MFE Course Details. Financial Mathematics & Statistics

Introduction to Probability Theory and Stochastic Processes for Finance Lecture Notes

Monte Carlo Simulation of Stochastic Processes

Mathematical Modeling and Methods of Option Pricing

Diffusions, Markov Processes, and Martingales

Advanced Stochastic Processes.

Introduction to Stochastic Calculus With Applications

Reading: You should read Hull chapter 12 and perhaps the very first part of chapter 13.

S t d with probability (1 p), where

Drunken Birds, Brownian Motion, and Other Random Fun

MSc Financial Engineering CHRISTMAS ASSIGNMENT: MERTON S JUMP-DIFFUSION MODEL. To be handed in by monday January 28, 2013

The Use of Importance Sampling to Speed Up Stochastic Volatility Simulations

Last Time. Martingale inequalities Martingale convergence theorem Uniformly integrable martingales. Today s lecture: Sections 4.4.1, 5.

Multi-Asset Options. A Numerical Study VILHELM NIKLASSON FRIDA TIVEDAL. Master s thesis in Engineering Mathematics and Computational Science

Replication strategies of derivatives under proportional transaction costs - An extension to the Boyle and Vorst model.

1 Interest Based Instruments

ADVANCED ASSET PRICING THEORY

The Impact of Volatility Estimates in Hedging Effectiveness

STOCHASTIC CALCULUS AND BLACK-SCHOLES MODEL

ICEF, Higher School of Economics, Moscow Msc Programme Autumn Derivatives

MFE Course Details. Financial Mathematics & Statistics

HEDGING BY SEQUENTIAL REGRESSION : AN INTRODUCTION TO THE MATHEMATICS OF OPTION TRADING

Learning Martingale Measures to Price Options

SECOND EDITION. MARY R. HARDY University of Waterloo, Ontario. HOWARD R. WATERS Heriot-Watt University, Edinburgh

Lecture 11: Ito Calculus. Tuesday, October 23, 12

Monte Carlo Methods in Financial Engineering

The Mathematics of Currency Hedging

CRANK-NICOLSON SCHEME FOR ASIAN OPTION

Continuous Time Finance. Tomas Björk

SOA Exam MFE Solutions: May 2007

Portfolio optimization problem with default risk

Advanced Topics in Derivative Pricing Models. Topic 4 - Variance products and volatility derivatives

Lecture Note 8 of Bus 41202, Spring 2017: Stochastic Diffusion Equation & Option Pricing

Option Pricing Models for European Options

Hedging under Arbitrage

Practical Hedging: From Theory to Practice. OSU Financial Mathematics Seminar May 5, 2008

Optimal trading strategies under arbitrage

Chapter 15: Jump Processes and Incomplete Markets. 1 Jumps as One Explanation of Incomplete Markets

Geometric Brownian Motion (Stochastic Population Growth)

Master of Science in Finance (MSF) Curriculum

Non-semimartingales in finance

Black Scholes Equation Luc Ashwin and Calum Keeley

Course MFE/3F Practice Exam 1 Solutions

Aspects of Financial Mathematics:

Transcription:

Oscar Pérez

Objective Binomial Model What is and what is not mortgage insurance in Mexico? 3 times model (Black and Scholes) Correlated brownian motion Other concepts Conclusions

To explain some technical aspects of Mortgage Insurance in a formal document. To apply some techniques of risk management to the actuarial science. To propose a methodology for estimation of losses based on information of the risks. To solve some operating problems of insurance companies related to information quality. To avoid stochastic simulation! Have you tried to get a closed formula before simulation?

Let M be a stochastic process which represents the number of payments that has not been paid by a creditor of a mortgage loan. This process will be called: DELINQUENCY INDEX

Other ingredients: Insurance function which represent the payment of an insurance company depending on the delinquency index: Risk free cash bond : Stochastic process.

Finally the trees! (sorry, just a branch) For the delincuency index: 0 p 0 1-p 0 u d M 0 M 1 For the insurance function: p 0 0 1-p 0 f(u) f(d) M 0 M 1

With these trees it is possible to find and present value of the expected value of the losses of a company: We can interpret this formula considering the Kolmogorov s strong law of large numbers. According to that law, if the company has a portfolio of insurance policies sufficiently large, that company can expect a loss given by this formula.

Now consider and Asset which value depends on mortgage loans performance, that is, a Morgage Back Security: MBS Trendy word. Supose that the Mortgage insurance company wishes to hedge or to match its losses by using a portfolio containing Mortgage back securities and the risk free cash bond. That is:

In order to carry out that hedging estrategy, it is necessary to construct the following system of equations: If we solve it and substitute in the portfolio expresion, we have:

Or.. With In this way we have found another expected value of the losses of the company by making a change of probability let s say Q. This process is used in financial derivatives valuation.

The existence of the probability measure Q is equivalent to state that the present value of the asset that depends on the delinquency index MBS process, is a MARTINGALE. In our example: Remember that an adaptive process is a Martingale if:

To make a generalization of the model it is important to be familiar with: Probability measure, Filtration (very important!!), Financial Claim, Conditional expectation, Adaptive and previsible processes, Martingale. This concepts can be used to develop the binomial model for n branches in the same way as before. Nevertheless the important result is that by calculating the expected value of the losses of a mortgage insurancre company and making the change of probability, the present value of the asset that depends on the delinquency index process, is a MARTINGALE.

It is: Tool for transferring credit risk in mortgages. will pay the benefit only when financial institution takes over the house due to default. It covers just a portion of the OB + interest up to taking over the house. It is not: Unemployment insurance. Financial warranty insurance (MBS) Classical P&C insurance. It Started in november 30 2006 when the regulator enacted the Rules for Mortgages Insurances

A mortgage insurance company has to constitue: Mathematical Reserve (actuarial or premium reserve) Catastrophic Reserve (50% of the risk premium + i) Capital (depending on seasoning and LTV) Claims reserves (Outstanding reserves). Based on the DELINQUENCY INDEX. That is this reserve can be calculated as a expected vaule of the losses of a company. The rest of the presentation will be related with claims reserve.

Please, imagine that the two branches example tree has now an infinite number of branches. That idea leads us to important concepts Brownian motion Difussions Stochastic calculus: Black and Scholes Model Ito lemma Ito processes (martingale if drift is 0):

Supose that M Delinquency index is a geometric brownian motion: The risk free chash bond is another difussion: The present value of the MBS which is a deterministic linear function:

This model is based in the fact that the present value of the MBS is a Martingale under a change of probabilty. So by using the following techniques of estochastic calculus: Ito s lemma Martin Cameron Girsanov Theorem We get: And:

Now we calculate the expected losses as: By applying the Black and Scholes Methodoly, we have: With:

3 times in the model: information, valuation, time when the claim is paid. If u is a constant: By using other techniques of stochastic calculus (Ito s lemma) it is possible to obtain the hedging portfolio:

It is possible to adjust the Delinquency index defined in the 3 times model by using another brownian motion. If we define the following expresion as the Total delinquency index (both factors are geometric brownnian motion: By using the integration by parts lemma it can be demonstrated that:

If we consider the Total volatility and the following process: We have another brownian model for the Total delinquency index:

And we can use the techniques used inthe 3 ties model: We do not have to know the drift of the processes nor even the exact correlations of the brownian motion. It can be shown that:

This techniques can be used for: Pricing (simulation is required) Mathematical Reserves Capital:

Applaying these concepts to sample of a real portfolio to estimate future losses we have: Regulator 3 times model CORRELATED BROWNIAN MOTION Var of MM tt 2 Var 5% Var 25% Var 50% Var 75% Var 100% 1,167.12 785.45 740.39 623.52 533.10 467.29 415.23 Also for the pricing: Coverage 20% 25% 30% Benefit premiums 1.04% 1.30% 1.56% Level premium 0.00% 0.01% 0.01%

Some techniques of stochastic calculus can be applied in the estimation of losses for mortgage insurances Special attention should be paid to the normality assumptions that the Black and Scholes model implies In the numerical results we can show that it is possible to have shorter reserves requirements. The 3 times model allows to remove the markovian approach of the current regulatory requirements in Mexico, it can be used to solve some operational problems Score models.