What Can Quantitative Risk Management

Contribute To Data Science?

Dr. Dimitrios Geromichalos *)
Introduction
What can Silicon Valley learn from Wall Street? could be another wording of this question.
Indeed, the last years have seen tremendous developments in two statistics-related and
highly mathematized areas data science (DS) and quantitative risk management (QRM).
However, though often tackling similar problems they evolved mainly parallel to each other.
Cultural reasons of the main areas of their application (Silicon Valley vs. Wall Street) could
be a reason for this separate development. Difficulties to communicate concepts in highly
complex frameworks could be another one.
Of course there exist already some topics were the two areas were successfully merged.
News-based algorithmic trading is one well-known example. Other examples include e.g.
web-based reputation risk management, big data based rogue trading detection, and newsbased credit rating early warning systems.
But this is only the tip of the iceberg. Both areas can also contribute to each other on a more
fundamental conceptual level. The aim of this article is to draft some examples where both
areas already use similar concepts and to provide some suggestions of concepts which are
well established in QRM and could be also useful for DS applications.

Different areas similar solutions

The basic skillsets for quantitative risk managers and data scientists have a huge overlap
concerning the mathematical and statistical knowhow. Also, the problems of both areas are
often similar (e.g. credit rating development which basically is data science). Thus it is not
really surprising that many concepts used in DS are also well-established in QRM though
the nomenclatures and details often differ. Some concepts used in both worlds include

Regression: The main aim of QRM is to provide stable statements about possible
future developments. Regression techniques are frequently used for this task.
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The most commonly one is the most simple: The linear regression which is
used e.g. to simulate future movements of stock price yields. (In this case,
generally the logarithm of the stock price is assumed being linear and thus
the yield constant.) Another case is e.g. the replacement of missing data with
reference values.

Logistic regressions are commonly used for calculating credit ratings: To

discriminate between default and non-default but also to benchmark
internal ratings to external ones from the rating agencies.

Time series: Here applies the same as for regressions. Especially for interest rate
models, concepts like ARIMA or GARCH are commonly used at least in academia.
Since many parameters, like inflation curves, have seasonality patterns seasonality
adjustments are common practice.

ROC: In order to validate e.g. rating models, concepts similar to ROC or lift curves
are used in QRM (though generally termed as discriminatory power).

Feature selection: Many areas of QRM like interest curve or credit portfolio
modeling have to do with a great number of different parameters. In order to reduce
them diagonalization techniques (like PCA in the simplest case) are used. Also,
regressions require often further simplification. Here, forward selection and backward
elimination are the methods of choice.

k-nn: Classification methods have not entered into QRM, yet. However, the usage of
data sets as blueprint for simulations is already established and called historical
simulation.

What quantitative risk management can contribute to data science

After the short introduction of some concepts commonly used in QRM and DS, there follow
some (not complete and preliminary) suggestions of QRM methods currently not used in DS.

Value at risk (VaR), expected shortfall (ES), and other distribution-related figures: If
there is one basic risk management lesson it is that predicting just the expected value
of a statistic figure is dangerous at best. To cover this issue, several techniques have
been developed that consider distributions and focus on certain bad cases. Here,
despite its diverse shortcomings, the quantile-based VaR is the one most commonly
used. Other methods like the ES consider complete distributions of bad cases
and are more stable under some statistical criteria like sub-additivity. Distribution
considerations may play an important role in many DS solutions (like predicting
revenues) and QRM could provide the required toolset. (This issue should become
more important in the next time due to business reasons since risk considerations
begin also to play a role in the controlling procedures of corporates.)

Monte Carlo methods: Are Monte Carlo simulations data science? Though many may
disagree, it should be taken into account that Monte Carlo simulations are basically
also means to get information from data sets. Monte Carlo simulations are
excessively used in QRM and several methodologies (i.e. Cholesky decomposition for
generating correlated random numbers) are implemented and could be of use for
basically every use case that has to do with prediction.

Correlation modeling and diversification: As mentioned, measuring default rates is an

important part of QRM. But QRM goes much farther. Correlations of defaults of
counterparties are also considered as well as higher correlations of branches and
regions. The respective portfolio models are possibly the most complex ones QRM
has developed yet and are often proprietary, like e.g. CreditMetrics or CreditRisk+
but there exist also free and simple alternatives. Why should such methods not also
be applied in fraud detection or supply chain management solutions?

Migration matrices: Credit ratings deal with default probabilities in a certain time
period which is generally one year. A customer assigned to a better rating class has a
lower default probability than a customer assigned to a worse one. But what about
larger lime periods of several years? Here, in QRM the migration matrix method has
been established. A migration or transition matrix provides not only the default
probability in a year but also the migration probabilities for a customer to migrate
into another rating class (e.g. A to A, A to AA, B to A, B to AA, B to default, etc.).
Default probabilities for longer time periods can then be obtained quite easily via
matrix multiplications. Why not use this method not also for other rating types (fraud,
etc.)?

The future influences the present: Perhaps the most striking feature of financial
mathematics is that the (expected) future influences the present. The valuation of
most financial products must include also the expectation about future revenues
(cash flows). But this is not just a feature of financial products. Humans always tend
to plan for the future and thus everything parameter that has to do with human
behavior is influenced by some future expectations.

The model influences the reality: Another peculiar feature of financial math is that
market participants act differently if they learn more about how the market works. This
is a big difference e.g. to physics and seems paradoxical. However, e.g. the market
values of stock options have clearly changed after the introduction of the BlackScholes model. Could there be also a Black-Scholes moment for DS?

A simple plot the heatmap: Finally a suggestion that has just to do with visualizing
results. In QRM, in order to show bad cases more clearly, the frequency of damages
is generally plotted over the severity as scatterplots. Each area of the plot has a
discrete color that gives an indication about the necessity to act. Such heatmaps are
simple to set up and easy to communicate. They can also be easily adapted to other
kinds of variables (e.g. severity over time horizon).

Summarizing, the areas data science and quantitative risk management have lot of
similarities but also often quite different approaches. Both areas can only profit from the
gained knowledge of the other one.

*) Twitter: @dg_risk