stein's method and zero bias transformation: application...
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Stein’s method and zero bias transformation:Application to CDO pricing
Ying Jiao
ESILV and Ecole Polytechnique
Joint work with N. El Karoui
Ying Jiao Stein’s method and zero bias transformation for CDOs
Introduction
CDO — a portfolio credit derivative containing ≈ 100underlying names susceptible to default risk.
Key term to calculate: the cumulative lossLT =
∑ni=1 Ni(1− Ri)11{τi≤T} where Ni is the nominal of
each name and Ri is the recovery rate.
Pricing of one CDO tranche: call function E[(LT − K )+]with attachment or detachment point K .
Motivation: fast and precise numerical method for CDOs inthe market-adopted framework
Ying Jiao Stein’s method and zero bias transformation for CDOs
Factor models
Standard model in the market: factor model withconditionally independent defaults.
Normal factor model: Gaussian copula approach
{τi ≤ t} = {ρiY +√
1− ρ2i Yi ≤ N−1(αi(t))} where
Yi ,Y ∼ N(0,1) and independent, and αi(t) is the averageprobability of default before t .
Given Y (not necessarily normal), LT is written as sum ofindependent random variablesLT follows binomial law for homogeneous portfoliosCentral limit theorems: Gaussian and Poissonapproximations
Ying Jiao Stein’s method and zero bias transformation for CDOs
Some approximation methods
Gaussian approximation in finance:Total loss of a homogeneous portfolio (Vasicek (1991)),normal approximation of binomial distributionOption pricing: symmetric case (Diener-Diener (2004))Difficulty: n ≈ 100 and small default probability.
Saddle point method applied to CDOs(Martin-Thompson-Browne,Antonov-Mechkov-Misirpashaev): calculation time fornon-homogeneous portfolioOur solution: combine Gaussian and Poissonapproximations and propose a corrector term in each case.Mathematical tools: Stein’s method and zero biastransformation
Ying Jiao Stein’s method and zero bias transformation for CDOs
Stein method and Zero bias transformation
Ying Jiao Stein’s method and zero bias transformation for CDOs
Zero bias transformation
Goldstein-Reinert, 1997
-X a r.v. of mean zero and of variance σ2
-X ∗ has the zero-bias distribution of X if for all regular enough f ,
E[Xf (X )] = σ2E[f ′(X ∗)] (1)
-distribution of X ∗ unique with density pX∗(x) = E[X11{X>x}]/σ2.
Observation of Stein (1972): if Z ∼ N(0, σ2), thenE[Zf (Z )] = σ2E[f ′(Z )].
Ying Jiao Stein’s method and zero bias transformation for CDOs
Stein method and normal approximation
Stein’s equation (1972)
For the normal approximation of E[h(X )], Stein’s idea is to usefh defined as the solution of
h(x)− Φσ(h) = xf (x)− σ2f ′(x) (2)
where Φσ(h) = E[h(Z )] with Z ∼ N(0, σ2).
Proposition (Stein): If h is absolutely continuous, then∣∣E[h(X )]− Φσ(h)∣∣ =
∣∣σ2E[f ′h(X ∗)− f ′h(X )
]∣∣≤ σ2‖f ′′h ‖ E
[|X ∗ − X |
].
To estimate the approximation error, it’s important tomeasure the “distance” between X and X ∗ and thesup-norm of fh and its derivatives.
Ying Jiao Stein’s method and zero bias transformation for CDOs
Example and estimations
Example (Asymmetric Bernoulli distribution) :P(X = q) = p and P(X = −p) = q with q = 1− p. SoE(X ) = 0 and Var(X ) = pq. Furthermore, X ∗ ∼ U[−p,q].
If X and X ∗ are independent, then, for any even function g,
E[g(X ∗ − X )
]=
12σ2 E
[X sG(X s)
]where G(x) =
∫ x0 g(t)dt , X s = X − X̃ and X̃ is an
independent copy of X .
In particular, E[|X ∗ − X |] = 14σ2 E
[|X s|3
] (∼ O
( 1√n
)).
E[|X ∗ − X |k ] = 12(k+1)σ2 E
[|X s|k+2] (
∼ O( 1√
nk
)).
Ying Jiao Stein’s method and zero bias transformation for CDOs
Sum of independent random variables
Goldstein-Reinert, 97Let W = X1 + · · ·+ Xn where Xi are independent r.v. of meanzero and Var(W ) = σ2
W <∞. Then
W ∗ = W (I) + X ∗I ,
where P(I = i) = σ2i /σ
2W . W (i) = W − Xi . Furthermore, W (i),
Xi , X ∗i and I are mutually independent.
Here W and W ∗ are not independent.E[|W ∗ −W |k
]= 1
2(k+1)σ2W
∑ni=1 E
[|X s
i |k+2] (
∼ O( 1√
nk
)).
Ying Jiao Stein’s method and zero bias transformation for CDOs
Conditional expectation technic
To obtain an addition order in the estimations, for example,
E[XI |X1, · · · ,Xn] =∑n
i=1σ2
iσ2
WXi , then,
E[E[XI |X1, · · · ,Xn]2] =∑n
i=1σ6
iσ4
Wis of order O( 1
n2 ).
However, E[X 2I ] is of order O( 1
n ).This technic is crucial for estimating E[g(XI ,X ∗I )] andE[f (W )g(XI ,X ∗I )].
Ying Jiao Stein’s method and zero bias transformation for CDOs
First order Gaussian correction
TheoremNormal approximation ΦσW (h) of E[h(W )] has corrector :
Ch =1
2σ4W
n∑i=1
E[X 3i ]ΦσW
(( x2
3σ2W− 1)
xh(x)
)(3)
where h has bounded second order derivative.The corrected approximation error is bounded by∣∣∣E[h(W )]− ΦσW (h)− Ch
∣∣∣ ≤ α(h,X1, · · · ,Xn)
where α(h,X1, · · · ,Xn) depends on ‖h′′‖ and moments of Xi upto fourth order.
Ying Jiao Stein’s method and zero bias transformation for CDOs
Remarks
For i.i.d. asymmetric Bernoulli: corrector of order O( 1√n );
corrected error of order O( 1n ).
In the symmetric case, E[X ∗I ] = 0, so Ch = 0 for any h. Chcan be viewed as an asymmetric corrector.Skew play an important role.
Ying Jiao Stein’s method and zero bias transformation for CDOs
Ingredients of proof
development around the total loss W
E[h(W )]− ΦσW (h) = σ2W E[f ′′h (W )(X ∗I − XI)]
+ σ2W E[f (3)h
(ξW + (1− ξ)W ∗)ξ(W ∗ −W )2
].
by independence, E[f ′′h (W )X ∗I ] = E[X ∗I ]E[f ′′h (W )] =E[X ∗I ]ΦσW (f ′′h ) + E[X ∗I ]
(E[f ′′h (W )]− ΦσW (f ′′h )
).
use the conditional expectation technicE[f ′′h (W )XI ] = cov
(f ′′h (W ),E[XI |X1, · · · ,Xn]
).
write ΦσW (f ′′h ) in term of h and obtain
Ch = σ2W E[X ∗I ]ΦσW
(f ′′h)
= 1σ2
WE[X ∗I ]ΦσW
((x2
3σ2W− 1)
xh(x))
.
Ying Jiao Stein’s method and zero bias transformation for CDOs
Function “call”
Call function Ck (x) = (x − k)+: absolutely continuous withC′k (x) = 11{x>k}, but no second order derivative.Hypothesis not satisfied.
Same corrector
∣∣E[(W − k)+]− ΦσW ((x − k)+)− 13
E[X ∗I ]kφσW (k)∣∣ ∼ O(
1n
).
Error bounds depend on |f ′Ck|, |xf ′′Ck
|.
Ingredients of proof:write f ′′Ck
as more regular function by Stein’s equationConcentration inequality (Chen-Shao, 2001)
Corrector Ch = 0 when k = 0, extremal values whenk = ±σ2
Ying Jiao Stein’s method and zero bias transformation for CDOs
Normal or Poisson?
The methodology works for other distributions.Stein’s method in Poisson case (Chen 1975): a r.v. Λtaking positive integer values follows Poisson distributionP(λ) iif E[Λg(Λ)] = λE[g(Λ + 1)] := APg(Λ).Poisson zero bias transformation X ∗ for X with E[X ] = λ:E[Xg(X )] = E[APg(X ∗)]
Stein’s equation :
h(x)− Pλ(h) = xg(x)−APg(x) (4)
where Pλ(h) = E[h(Λ)] with Λ ∼ P(λ).
Ying Jiao Stein’s method and zero bias transformation for CDOs
Poisson correction
Poisson corrector of PλW (h) for E[h(W )] :
CPh =λW
2PλW
(∆2h
)E[X ∗I − XI
]where ∆h(x) = h(x + 1)− h(x) and P(I = i) = λi/λW .
Proof: combinatory technics for integer valued r.v.For h = (x − k)+, ∆2h(x) = 11{x=k−1}, then
CPh =σ2
W − λW
2(bkc − 1)!e−λWλ
bkc−1W .
Ying Jiao Stein’s method and zero bias transformation for CDOs
Numerical tests: E[(Wn − k)+]
E[(Wn − k)+] in function of nσW = 1 and k = 1 (maximal Gaussian correction) forhomogeneous portfolio.Two graphes : p = 0.1 and p = 0.01 respectively.Oscillation of the binomial curve and comparison ofdifferent approximations.
Ying Jiao Stein’s method and zero bias transformation for CDOs
Numerical tests: E[(Wn − k)+]
Legend : binomial (black), normal (magenta), correctednormal (green), Poisson (blue) and corrected Poisson(red). p = 0.1,n = 100.
0 50 100 150 200 250 300 350 400 450 5000.08
0.09
0.1
0.11
0.12
0.13
0.14
0.15
n
binomial normal normal with correction poisson poisson with correction
Ying Jiao Stein’s method and zero bias transformation for CDOs
Numerical tests : E[(Wn − k)+]
Legend : binomial (black), normal (magenta), correctednormal (green), Poisson (blue) et corrected Poisson (red).p = 0.01,n = 100.
0 50 100 150 200 250 300 350 400 450 5000.08
0.1
0.12
0.14
0.16
0.18
0.2
0.22
n
binomial normal normal with correction poisson poisson with correction
Corrected Poisson approximation remains precise even forp = 0.1.
Ying Jiao Stein’s method and zero bias transformation for CDOs
Higher order corrections
The regularity of h plays an important role.Second order approximation is given by
C(2,h) = ΦσW (h) + Ch
+ ΦσW
(( x6
18σ8W− 5x4
6σ6W
+5x2
2σ4W
)(h(x)− ΦσW (h))
)E[X ∗I ]2
+12
ΦσW
(( x4
4σ6W− 3x2
2σ4W
)h(x)
)(E[(X ∗I )2]− E[X 2
I ]).
(5)
Since the call function is not regular enough, it’s difficult tocontrol errors.
Ying Jiao Stein’s method and zero bias transformation for CDOs
Applications to CDOs
In collaboration with David KURTZ (Calyon, Londres).
Ying Jiao Stein’s method and zero bias transformation for CDOs
Normalization for loss
Percentage loss lT = 1n∑n
i=1(1− Ri)11{τi≤T}K = 3%,6%,9%,12%.Normalization for ξi = 11{τi≤T} : let Xi = ξi−pi√
npi (1−pi )where
pi = P(ξi = 1). Then E[Xi ] = 0 and Var[Xi ] = 1n .
Suppose Ri = 0 and pi = p for simplicity. Letp(Y ) = pi(Y ) = P(τi ≤ T |Y ). Then
E[(lT−K )+|Y
]=
√p(Y )(1− p(Y ))
nE[(W−k(n,p(Y )))+|Y
].
where W =∑n
i=1 Xi and k(n,p) = (K−p)√
n√p(1−p)
.
Constraint in Poisson case: Ri deterministic andproportional.
Ying Jiao Stein’s method and zero bias transformation for CDOs
Numerical tests: domain of validity
Conditional error of E[(lT − K )+], in function of K/p,n = 100.
Inhomogeneous portfolio with log-normal pi of mean p.
Ying Jiao Stein’s method and zero bias transformation for CDOs
Numerical tests : Domain of validity
Legend : corrected Gaussian error (blue), correctedPoisson error (red). np=5 and np=20.
np=5
-0.010%
-0.005%
0.000%
0.005%
0.010%
0.015%
0.020%
0% 100% 200% 300%
Error Gauss Error Poisson
np=20
-0.008%-0.006%-0.004%-0.002%0.000%0.002%0.004%0.006%0.008%0.010%0.012%
0% 100% 200% 300%
Error Gauss Error Poisson
Domain of validity : np ≈ 15Maximal error : when k near the average loss; overlappingarea of the two approximations
Ying Jiao Stein’s method and zero bias transformation for CDOs
Comparison with saddle-point method
Legend : Gaussian error (red), saddle-point first order error(blue dot), saddle-point second order error (blue). np=5and np=20.
np=5
-0.040%
-0.030%
-0.020%
-0.010%
0.000%
0.010%
0.020%
0.030%
0.040%
0% 100% 200% 300%
Gauss Saddle 1 Saddle 2
np=20
-0.025%
-0.020%
-0.015%
-0.010%
-0.005%
0.000%
0.005%
0.010%
0.015%
0.020%
0.025%
0% 100% 200% 300%
Gauss Saddle 1 Saddle 2
Ying Jiao Stein’s method and zero bias transformation for CDOs
Numerical tests : stochastic Ri
Conditional error of E[(lT − K )+], in function of K/p forGaussian approximation error with stochastic Ri .
Ri : Beta distribution with expectation 50% and variance26%, independent (Moody’s).
Corrector depends on the third order moment of Ri .Confidence interval 95% by 106 Monte Carlo simulation.
Ying Jiao Stein’s method and zero bias transformation for CDOs
Numerical tests : stochastic Ri
Gaussian approximation better when p is large as in thestandard case. np=5 and np=20.
np=5
-0.005%-0.004%-0.003%-0.002%-0.001%0.000%0.001%0.002%0.003%0.004%
0% 100% 200% 300%
Lower MC Bound Gauss Error Upper MC Bound
np=20
-0.006%
-0.004%
-0.002%
0.000%
0.002%
0.004%
0.006%
0% 100% 200%
Lower MC Bound Gauss Error Upper MC Bound
Ying Jiao Stein’s method and zero bias transformation for CDOs
Real-life CDOs pricing
Parametric correlation model of ρ(Y ) to match the smile.Method adapted to all conditional independent models, notonly in the normal factor model caseNumerical results compared to the recursive method(Hull-White)Calculation time largely reduced: 1 : 200 for one price
Ying Jiao Stein’s method and zero bias transformation for CDOs
Real-life CDOs pricing
Error of prices in bp (10−4) for corrected Gauss-Poissonapproximation with realistic local correlation.Expected loss 4%− 5%
Break Even Error
-0.20
-
0.20
0.40
0.60
0.80
1.00
1.20
1.40
0-3 3-6 6-9 9-12 12-15 15-22 0-100
Break Even Error
Ying Jiao Stein’s method and zero bias transformation for CDOs
Conclusion remark and perspective
Tests for VaR and sensitivity remain satisfactory
Perspective: remove the deterministic recovery ratecondition in the Poisson case.
Ying Jiao Stein’s method and zero bias transformation for CDOs