Section: Research Program

Risk management: modeling and optimization

Contagion modeling and systemic risk

After the recent financial crisis, systemic risk has emerged as one of the major research topics in mathematical finance. Interconnected systems are subject to contagion in time of distress. The scope is to understand and model how the bankruptcy of a bank (or a large company) may or not induce other bankruptcies. By contrast with the traditional approach in risk management, the focus is no longer on modeling the risks faced by a single financial institution, but on modeling the complex interrelations between financial institutions and the mechanisms of distress propagation among these.

The mathematical modeling of default contagion, by which an economic shock causing initial losses and default of a few institutions is amplified due to complex linkages, leading to large scale defaults, can be addressed by various techniques, such as network approaches (see in particular R. Cont et al. [40] and A. Minca [79]) or mean field interaction models (Garnier-Papanicolaou-Yang [70]).

We have contributed in the last years to the research on the control of contagion in financial systems in the framework of random graph models : In [41], [80], [5], A. Sulem with A. Minca and H. Amini consider a financial network described as a weighted directed graph, in which nodes represent financial institutions and edges the exposures between them. The distress propagation is modeled as an epidemics on this graph. They study the optimal intervention of a lender of last resort who seeks to make equity infusions in a banking system prone to insolvency and to bank runs, under complete and incomplete information of the failure cluster, in order to minimize the contagion effects. The paper [5] provides in particular important insight on the relation between the value of a financial system, connectivity and optimal intervention.

The results show that up to a certain connectivity, the value of the financial system increases with connectivity. However, this is no longer the case if connectivity becomes too large. The natural question remains how to create incentives for the banks to attain an optimal level of connectivity. This is studied in [54], where network formation for a large set of financial institutions represented as nodes is investigated. Linkages are source of income, and at the same time they bear the risk of contagion, which is endogeneous and depends on the strategies of all nodes in the system. The optimal connectivity of the nodes results from a game. Existence of an equilibrium in the system and stability properties is studied. The results suggest that financial stability is best described in terms of the mechanism of network formation than in terms of simple statistics of the network topology like the average connectivity.

Liquidity risk and Market Microstructure

Liquidity risk is the risk arising from the difficulty of selling (or buying) an asset. Usually, assets are quoted on a market with a Limit Order Book (LOB) that registers all the waiting limit buy and sell orders for this asset. The bid (resp. ask) price is the most expensive (resp. cheapest) waiting buy or sell order. If a trader wants to sell a single asset, he will sell it at the bid price, but if he wants to sell a large quantity of assets, he will have to sell them at a lower price in order to match further waiting buy orders. This creates an extra cost, and raises important issues. From a short-term perspective (from few minutes to some days), it may be interesting to split the selling order and to focus on finding optimal selling strategies. This requires to model the market microstructure, i.e. how the market reacts in a short time-scale to execution orders. From a long-term perspective (typically, one month or more), one has to understand how this cost modifies portfolio managing strategies (especially delta-hedging or optimal investment strategies). At this time-scale, there is no need to model precisely the market microstructure, but one has to specify how the liquidity costs aggregate.

For rather liquid assets, liquidity risk is usually taken into account via price impact models which describe how a (large) trader influences the asset prices. Then, one is typically interested in the optimal execution problem: how to buy/sell a given amount of assets optimally within a given deadline. This issue is directly related to the existence of statistical arbitrage or Price Manipulation Strategies (PMS). Most of price impact models deal with single assets. A. Alfonsi, F. Klöck and A. Schied  [39] have proposed a multi-assets price impact model that extends previous works. Price impact models are usually relevant when trading at an intermediary frequency (say every hour). At a lower frequency, price impact is usually ignored while at a high frequency (every minute or second), one has to take into account the other traders and the price jumps, tick by tick. Midpoint price models are thus usually preferred at this time scale. With P. Blanc, Alfonsi [3] has proposed a model that makes a bridge between these two types of model: they have considered an (Obizhaeva and Wang) price impact model, in which the flow of market orders generated by the other traders is given by an exogeneous process. They have shown that Price Manipulation Strategies exist when the flow of order is a compound Poisson process. However, modeling this flow by a mutually exciting Hawkes process with a particular parametrization allows them to exclude these PMS. Besides, the optimal execution strategy is explicit in this model. A practical implementation is given in [35].

Dependence modeling

- Calibration of stochastic and local volatility models. The volatility is a key concept in modern mathematical finance, and an indicator of market stability. Risk management and associated instruments depend strongly on the volatility, and volatility modeling is a crucial issue in the finance industry. Of particular importance is the assets dependence modeling.

By Gyongy's theorem, a local and stochastic volatility model is calibrated to the market prices of all call options with positive maturities and strikes if its local volatility function is equal to the ratio of the Dupire local volatility function over the root conditional mean square of the stochastic volatility factor given the spot value. This leads to a SDE nonlinear in the sense of McKean. Particle methods based on a kernel approximation of the conditional expectation, as presented by Guyon and Henry-Labordère [71], provide an efficient calibration procedure even if some calibration errors may appear when the range of the stochastic volatility factor is very large. But so far, no existence result is available for the SDE nonlinear in the sense of McKean. In the particular case when the local volatility function is equal to the inverse of the root conditional mean square of the stochastic volatility factor multiplied by the spot value given this value and the interest rate is zero, the solution to the SDE is a fake Brownian motion. When the stochastic volatility factor is a constant (over time) random variable taking finitely many values and the range of its square is not too large, B. Jourdain and A. Zhou proved existence to the associated Fokker-Planck equation [77]. Thanks to results obtained by Figalli in [63], they deduced existence of a new class of fake Brownian motions. They extended these results to the special case of the LSV model called Regime Switching Local Volatility, when the stochastic volatility factor is a jump process taking finitely many values and with jump intensities depending on the spot level.

- Interest rates modeling. Affine term structure models have been popularized by Dai and Singleton [55], Duffie, Filipovic and Schachermayer [56]. They consider vector affine diffusions (the coordinates are usually called factors) and assume that the short interest rate is a linear combination of these factors. A model of this kind is the Linear Gaussian Model (LGM) that considers a vector Ornstein-Uhlenbeck diffusions for the factors, see El Karoui and Lacoste  [62]. A. Alfonsi et al.  [33] have proposed an extension of this model, when the instantaneous covariation between the factors is given by a Wishart process. Doing so, the model keeps its affine structure and tractability while generating smiles for option prices. A price expansion around the LGM is obtained for Caplet and Swaption prices.

Robust finance

- Numerical Methods for Martingale Optimal Transport problems.

The Martingale Optimal Transport (MOT) problem introduced in [53] has received a recent attention in finance since it gives model-free hedges and bounds on the prices of exotic options. The market prices of liquid call and put options give the marginal distributions of the underlying asset at each traded maturity. Under the simplifying assumption that the risk-free rate is zero, these probability measures are in increasing convex order, since by Strassen's theorem this property is equivalent to the existence of a martingale measure with the right marginal distributions. For an exotic payoff function of the values of the underlying on the time-grid given by these maturities, the model-free upper-bound (resp. lower-bound) for the price consistent with these marginal distributions is given by the following martingale optimal transport problem : maximize (resp. minimize) the integral of the payoff with respect to the martingale measure over all martingale measures with the right marginal distributions. Super-hedging (resp. sub-hedging) strategies are obtained by solving the dual problem. With J. Corbetta, A. Alfonsi and B. Jourdain [36] have studied sampling methods preserving the convex order for two probability measures $\mu$ and $\nu$ on ${𝐑}^d$, with $\nu$ dominating $\mu$.

Their method is the first generic approach to tackle the martingale optimal transport problem numerically and can also be applied to several marginals.

- Robust option pricing in financial markets with imperfections.

A. Sulem, M.C. Quenez and R. Dumitrescu have studied robust pricing in an imperfect financial market with default. The market imperfections are taken into account via the nonlinearity of the wealth dynamics. In this setting, the pricing system is expressed as a nonlinear g-expectation ${ℰ}^g$ induced by a nonlinear BSDE with nonlinear driver $g$ and default jump (see [24]). A large class of imperfect market models can fit in this framework, including imperfections coming from different borrowing and lending interest rates, taxes on profits from risky investments, or from the trading impact of a large investor seller on the market prices and the default probability. Pricing and superhedging issues for American and game options in this context and their links with optimal stopping problems and Dynkin games with nonlinear expectation have been studied. These issues have also been addressed in the case of model uncertainty, in particular uncertainty on the default probability. The seller's robust price of a game option has been characterized as the value function of a Dynkin game under ${ℰ}^g$ expectation as well as the solution of a nonlinear doubly reflected BSDE in [9]. Existence of robust superhedging strategies has been studied. The buyer's point of view and arbitrage issues have also been studied in this context.

In a Markovian framework, the results of the paper [8] on combined optimal stopping/stochastic control with ${ℰ}^g$ expectation allows us to address American nonlinear option pricing when the payoff function is only Borelian and when there is ambiguity both on the drift and the volatility of the underlying asset price process. Robust optimal stopping of dynamic risk measures induced by BSDEs with jumps with model ambiguity is studied in [82].