Liquidity and Model

Risk

Pascal Gibart
Head of Model Validation

March 2010
Contents 2

03 Liquidity of the underlying

07 Distortion of Market Prices & Calibration
13 Liquidity trap
25 Conclusion

Liquidity & Model Risk – March 2010

Model and Model Risk 3

Model: framework to value complex derivative products

Model Risk: the risk that the model price is or will be in the future significantly
different from the market price (when such price is revealed) (Rebonato 2003: Theory
and Practice of Model Risk Management)

Models rely on a number of assumptions

most models assume continuous prices
capacity to buy and sell unlimited amounts of underlying asset
transaction costs (fees and bid ask) are negligible
Models use replication principle
static replication
dynamic replication
hedge costs are associated with these replications

Liquidity & Model Risk – March 2010

Liquidity can change 4

Liquidity & Model Risk – March 2010

Liquidity of the underlying 5

What happens when bid-ask widen?

Its quite easy to adjust quoted prices to clients in order to include initial hedge costs
10 bp for the delta, 0.5 volatility for the initial vega …..
Add a shift to the correlation and other non-tradable model parameter
Make a price

How to integrate the impact of the change in liquidity over the life of a complex transaction?
One could expect the subsequent hedges to be marginal compared to the size of the book
Unfortunately in some exotic books the trades tend to be more or less all the same!
Think of PRDC, Cancelable Range Accrual, Digital on CMS spreads, collar on stocks
As a result, the size of the book doesn’t help anymore and the books will lose money on a daily
basis because of hedge costs
As the maturity of trades tends to lengthen in periods of low volatility, this creates positions that
will become hard to manage during the next crisis!

Liquidity & Model Risk – March 2010

Liquidity of the underlying 6

What can be done?

Simulate future hedge costs and reserve them upfront

To be on the safe side one can also evaluate these costs in a stressed environment
Change the volatilities, the volatility of volatility in your calibrated models in order to
estimate future hedge costs (à la Leland 1985)
whatever the approach it is not easy!

Liquidity & Model Risk – March 2010

Distortion of Market Prices 7

Valuation Model are based on relative value

a model gives the price of a complex payoff as a function of the price of vanilla
We rely on the efficient market hypothesis to conduct relative value analysis
When liquidity disappears this nice market feature is not necessarily true
anymore…
LTCM used to buy Off-the-Run long dated Treasuries and sell the On-the-Run
equivalent Treasuries for a few basis points pick up
Looks like a very low risk strategy. Can yield of equivalent bonds (30-year against 29 ½ year)
really be apart by more than a few basis points?
Part of the “back to normal” or “convergence” type of trades
Problem: it takes time to lock in the profit and there is a hidden risk of squeeze in case of a
“flight to liquidity” and that is precisely what happened after the Russian default
arbitrage are very sensitive to liquidity issues
In a Mark-to-Market environment such gap can even get wider when trader hit limits or funds
meet redemptions and need as a result to unwind the arbitrage

Liquidity & Model Risk – March 2010

Distortion of Market Prices 8

SX5E Dividend
2002 82.79
2003 70.85
2004 83.25
2005 99.04
2006 121.88
2007 146.52
2008 158.55
2009 115.5*

Liquidity & Model Risk – March 2010

Distortion of Market Prices and calibration 9

There is another tricky aspect behind such distortion of market prices when they arise in
calibration instruments

Models will be calibrated based on these distorted prices and then prices of more complex
products are affected in a non trivial manner!

CMS Spreads 10y-2Y compared to forward spread

10/09/2009 22/12/2008 20/06/2008 14/12/2007 05/12/2006
0,34% 0,28% 0,17% 0,14% 0,14%
0,65% 0,67% 0,32% 0,26% 0,24%

Liquidity & Model Risk – March 2010

Distortion of Market Prices and Calibration 10

Swap and CMS Spreads 10y-2y in 2009

1,4%

1,2%

1,0%

0,8%

0,6%

0,4%

0,2%

0,0%
1y 2y 3y 4y 5y 6y 7y 8y 9y 10y 11y 12y 13y 14y 15y 16y 17y 18y 19y 20y
-0,2%

-0,4%

-0,6%

-0,8%

CMS Spread Diff Sw ap

Liquidity & Model Risk – March 2010

Distortion of Market Prices and calibration 11

Swap and CMS Spreads 10y-2y in 2006

0,3%

0,3%

0,2%

0,2%

0,1%

0,1%

0,0%
1y 2y 3y 4y 5y 6y 7y 8y 9y 10y 11y 12y 13y 14y 15y 16y 17y 18y 19y 20y
-0,1%

-0,1%

-0,2%

-0,2%

CMS Spread Diff Sw ap

Liquidity & Model Risk – March 2010

Distortion of Market Prices and calibration 12

In some circumstances the models will not be able to calibrate market prices anymore
CDO Super Senior in Gaussian Copula
multi factor Interest Rate Model with smile
complex copula for joint distribution of two currency pairs
Alternatively there might not be any market anymore for calibration instruments used by the
models
prices of deep out-of-the-money options
CMS spread options
More simple/robust models (“Plan B”) will be needed
calibrate more easily even if less precisely
use of historical estimates rather than implicit ones
always a good sanity check

Liquidity & Model Risk – March 2010

Liquidity Trap 13

In some circumstances (a mix of market dynamic and position of the exotic

community) underlying markets can become too thin to sustain the hedging
requirements of all exotic traders

This is a very difficult situation to identify particularly because historical

analysis does not help

On top of that, there is no real natural interest in the market to take the opposite
position: as a result the discrepancies tend to widen as exotic traders have
negative gamma positions

Liquidity & Model Risk – March 2010

Liquidity Trap 14

A theoretical example

Short option position (Call) on a single stock for a large size

Large negative gamma position : when market moves up you need to buy the stock

This in return adds to the upside pressure on the stock

It may also turn out that you are not alone with this position !

Liquidity & Model Risk – March 2010

Self Inflicted Liquidity Trap 15

Not so theoretical after all !

Liquidity & Model Risk – March 2010

 Liquidity Trap 16

It is (becoming) a regular situation in many markets

Volatility skew in Long Term FX options

Super senior CDO

CMS spreads in 2008

Who’s next?

Liquidity & Model Risk – March 2010

USD JPY Evolution of Risk Reversal 17

USD / JPY 10 Y Risk Reversal

0
d-99

d-00

d-01

d-02

d-03

d-04

d-05

d-06

d-07

d-08
-5
10d RR
-10
25d RR
-15

-20

-25

Liquidity & Model Risk – March 2010

USD JPY Evolution of Risk Reversal 18

USD / JPY 5 Y Risk Reversal

0
d-99

d-00

d-01

d-02

d-03

d-04

d-05

d-06

d-07

d-08
-5

10d RR
-10
25d RR

-15

-20

-25

Liquidity & Model Risk – March 2010

 100
120

20
40
60
80

0
12-sept-05

Liquidity & Model Risk – March 2010

09-Dec-2005

10-mars-06

06-juin-06

31-Aug-2006

29-nov-06

28-Feb-2007

24-May-2007

21-Aug-2007

19-nov-07

19-Feb-2008

15-May-2008
No offer on Super Senior Tranches ….

12-Aug-2008

07-nov-08

09-Feb-2009
CDX Main On the run (5Y) 30-100 Spread Mid

07-May-2009

04-Aug-2009
19
Risk Magazine Dec 2006: The Gamma Trap 20

Spread CMS10y- CMS2y EUR

2.5

1.5

0.5

0
janv.-99

janv.-00

janv.-01

janv.-02

janv.-03

janv.-04

janv.-05

janv.-06

janv.-07

janv.-08

janv.-09
-0.5

-1

Liquidity & Model Risk – March 2010

Liquidity Trap 21

Model are particularly poor to anticipate a change of regime

Generally they will not perform very well in such circumstances: prices of the
replication products will change abruptly in a way not predicted by the model and
losses will mount quickly

Some bet on a “return to normal situation” but it is a dangerous game since what
started the whole situation is very unlikely to disappear anytime soon and can indeed
easily get worse as more and more counterparties include the new market conditions
and adapt their hedge portfolio accordingly creating even more demand and price
distortion on these hedges that every one needs

Liquidity & Model Risk – March 2010

Liquidity Trap 22

What can be done?

Unfortunately the solution is not in better models but surely in better market risk
management

Stress analysis: reverse engineering

What would affect the price of my book?
What would make my hedge more costly?
At what point will my hedge strategy be constrained by the liquidity of the market? Am I
the only one with this hedge strategy or are all my colleagues in the same situation?
Will their be a natural flow of new interest to take on this hedge if the price move is
significant?

Liquidity & Model Risk – March 2010

Liquidity Trap 23

What can be done?

Try to find hedging transactions and market them to other customers, proprietary traders,
hedge funds that do not run exotic books

Be the first one to shoot! You will lose some money but that may help you save a lot!

Reduce the size of your portfolio: this will maybe allow you to sustain big market moves
as with a bigger size you would have hit your hedging and risk constraints and dispose of
the risk at the worse time

Liquidity & Model Risk – March 2010

Liquidity Trap 24

From the risk department point of view

Use all the intelligence gathered by the FO

Hit ratios and other elements that can help imagine the overall size of deals in the market
Ask for market quotes
Encourage trading in small size out of a complex product: it will be very instructive

Try as much as possible to use outside intelligence

Use market consensus
Use prices observed trough the collateral agreements
Some old friend in another bank or client will tell you how much your bank is out of market on
some specific trades!

Liquidity & Model Risk – March 2010

 Conclusion 25

Don’t take liquidity for granted !

Be prepared
Always think of a “Plan B” model that can be used in dire circumstances
Use this alternative model regularly as a sanity check
Look at what may go wrong if the hedges you rely upon suddenly become illiquid /
unavailable
Anticipate market saturation before you have to compete for the hedge
transactions

The solution is probably not in better models but rather in better risk management

Liquidity & Model Risk – March 2010