Market Risk Measurement

Lecture 1
What Is Market Risk Management?

Riccardo Rebonato
1 Plan of the Course

The aim of this course is to enable you

• to choose the most appropriate risk measurement method given the task
at hand;

• to measure the risk given the chosen measurement method;

• to be aware of what a trader, a business head, a head of risk, a Treasurer,

a CEO, a Board member, a regulator wants from you, the risk manager.
Normally this is more than just risk measurement.
This is an (approximate) plan of the course.
Figure 1: The plan of the course.
2 Plan of the lecture

This first lecture will be more theoretical than the rest of the course.

The reason for dwelling on more theoretical aspects is that the conceptual foun-
dations that we will lay today should remain with us, perhaps in the background,
for the rest of the course when we get down to work and measure market risk.

Even if our goal is to measure market risk, it is good to understand why we

want to measure what we measure.
Figure 2:
No prior knowledge of risk-neutral pricing, utility theory, different measures is
required for the course.

I will introduce these concepts in a heuristic and intuitive manner in the first
lecture.

We will only seldom explicitly use these concepts again, but please don’t erase
them from your memory.

I will introduce these concepts to make a few important points.

• The first point that I will try to make is that current risk practice and the
attending regulatory framework often give the impression that risk mea-
surement as the be-all-and-end-all of risk management — the implication
of this being that if we can measure risk well, then we can manage it just
as well.

In reality risk measurement is a necessary condition for good risk manage-

ment, but by no means all that is required for the task.

This is Important Message One.

• Next, what happened during the Great Recession of 2007-2008 gives us a
real-life laboratory experiment that anyone interested in risk management
cannot afford to ignore. I think this statement will remain valid even if
someone happens to read these notes in forty years’ time.

I will argue that if we want to understand what went wrong in risk man-
agement practices in 2007-2008, focussing on failures of risk measurement
may not be the best place to start.

Understanding the payoffs and the incentives of different players is essential

to make sense of real risk management and of how the real-world distribu-
tion of risk factors (the ‘thing’ that in a risk measurement course we learn
to estimate) gets ‘deformed’ when it is put to use. This is Important
Message Two.
• After all this theory, I will try to put the discussion of risk measures in its
historical context.

I will briefly sketch the origins of VaR as the risk measure of choice to
determine prudential capital.

The near-universal adoption of VaR in the first wave of risk-sensitive risk

management (instead of other risk measures) was almost serendipitous.

It did not have to end up this way.

When it comes to risk management/measurement, history is very path

dependent. This is Important Message Three.
• With this ‘historical’ part of the lecture under the belt, I will introduce risk
measures, and how they relate to ways of looking at risk which finance
theory ‘understands’.

Risk measure carry out a mapping from a loss distribution to a single

number. Remember, however: risk is a word and not a number (and some
say that it is a four-letter word!).

When we condense the information in the P&L distribution into a number

— or a handful of numbers — an enormous loss of information is entailed.
Perhaps there is no alternative, but the fact remains. This is Important
Message Four.

Text
 ?????
• Finally I will explain why the high-dimensional joint distribution of risk
factors and the univariate distribution of profits and losses (P&L) play
such a crucial role in risk measurement and management.

This is Very Important Message Five.

In mathematics, a univariate object is an expression, equation, function or polynomial involving only one variable. Objects
involving more than one variable are multivariate. In some cases the distinction between the univariate and multivariate
cases is fundamental; for example, the fundamental theorem of algebra and Euclid's algorithm for polynomials are
fundamental properties of univariate polynomials that cannot be generalized to multivariate polynomials.
3 Market Risk Measurement — A High-Level Per-
spective

At first glance, the discipline of risk measurement appears to be a well-established

subject, with a solid and rigorous theoretical grounding, axiomatic definitions,
etc. See Greenspan (2009):

The extraordinary risk-management discipline that developed out

of the writings of the University of Chicago’s Harry Markowitz in the
1950s produced insights that won several Nobel prizes in economics. It
was widely embraced not only by academia but also by a large majority
of financial professionals and global regulators.
In reality the way risk measurement is used for the purposes of risk manage-
ment has arisen from a rather serendipitous series of circumstances, historical
accidents, and ‘ideological’ positions

Yes, there is a theoretically well-grounded theory of decision-making under risk,

but the links between this theory and the practice of risk management for
financial institutions are rather tenuous.

For instance, the concept of ‘coherent’ risk measures, which we will encounter
later in this lecture, was developed after the VaR statistic had been enshrined
in the risk regulatory framework — and it so happens that VaR is not a coherent
measure of risk after all.
The current practical approach to risk management developed in substantial
disregard of some fundamental insights about the nature of risk from finance
theory and asset pricing.

Practice came first, and got a veneer of theoretical respectability afterwards.

This is not necessarily a bad thing, but we should not assume that risk mea-
surement (let alone risk management) stands on the same solid theoretical and
empirical grounds as, say, microeconomics.
Notwithstanding the quote above by Greenspan, the links with ‘the writings of
the University of Chicago’s Harry Markowitz’ are in reality rather tenuous.

The ‘story’ behind the emergence of the risk measurement discipline is much
‘messier’ than the usual text-book reconstructions allow one to perceive.
4 The Historical Origins of Value at Risk (VaR)

So, how did this practice evolve?

Source: Adamodar, (date unknown), Value at Risk (VaR), working paper, NYU

Theoretical origins of VaR in portfolio work by Markowitz et al. Emphasis of

Markowitz’s work on portfolio construction.

What this work has in common with VaR is the focus on the volatility of, and
correlation among, risk factors.
 • In the 1980s the US Securities and Exchange Commission (SEC) made the
first link between the capital held by financial firms and the potential losses
that would be incurred at the 95% confidence interval over a thirty-day
period. This capital was referred to as ‘haircut’, not as VaR.

• In 1986 Bankers’ Trust devised sophisticated measures of VaR (and intro-

duced the name) for its fixed-income portfolio.
La VaR (de l'anglais value at risk, mot à mot : « valeur à risque », ou « valeur en jeu ») est une notion utilisée
généralement pour mesurer le risque de marché d'un portefeuille d'instruments financiers. Elle correspond au montant
de pertes qui ne devrait être dépassé qu'avec une probabilité donnée sur un horizon temporel donné.
• By the early 1990s many trading desks computed VaR, and the quantity
could be more easily aggregated across different desks than traditional
measures such as PV01, CR01, etc. It became the natural measure for
firm-wide daily risk exposure.

At JP Morgan, it fulfilled the needs of its then-CEO (Dennis Weatherstone)

for a report that summarized succinctly the risk exposure of the firm. It
was called the ‘4:15 Report’ (that being the time 15 minutes before the
close of the US market).
• In 1994 JP Morgan made available for free their database on variances and
covariances among risk factors, and the technology (down to the decay
factor for the exponentially-decaying weights for volatilities) to turn these
quantities into a VaR statistic.

RiskMetrics was born.

• In 1997 the SEC required banks to provide information about their deriv-
atives positions.

Most banks co-ordinated their efforts and fulfilled the regulatory require-
ment via the use of VaR.

• In 1999 the Basel II Accord set out for the first time the possibility to calcu-
late the capital component pertaining to market risk using VaR calculated
using a firm’s internal methodology (to be approved by the regulators).

The underlying assumption: banks are centres of risk management

excellence.
5 Risk Management in the Wake of the Great
Recession

What went wrong?

The crisis of 2007-2008 have raised important questions about what went wrong
in the practice of risk management.

Any serious approach to risk management / measurement must ask a few

‘awkward’ questions.

For instance:
• Was it a failure of risk measurement (were the calculations of whatever
risk metrics was deemed useful faulty?)

• Were people using the wrong risk measures (ie, would the focus on risk
measures other than VaR have given rise to different outcomes)?

• Was it a failure of how the quantification of risk was used?

• Do we just have to ‘try harder’ (measure better)?

(Shreve 2008) writes:

‘When a bridge collapses, no one demands the abolition of civil engineering.

One first determines if faulty engineering or shoddy construction caused
the collapse. If engineering is to blame, the solution is better—not less—
engineering. Furthermore, it would be preposterous to replace the bridge
with a slower, less efficient ferry rather than to rebuild the bridge and
overcome the obstacle.’
• Had it all become too complicated?

(Greenspan, 2009):

‘It is clear that the levels of complexity to which market practitioners,

at the height of their euphoria, carried risk-management techniques and
risk-product design were too much for even the most sophisticated market
players to handle prudently.’

• Or where other causes at play?

In order to answer these questions we have to look more carefully at

• the payoffs that accrue to the various economic agents who are involved
in the management of risk;

• the implicit or explicit subsidies systemically important financial institutions

enjoy;

• the externalities these institutions impose on society;

• the current practical approach to risk management developed in substan-

tial disregard of some fundamental insights about the nature of risk from
finance theory and asset pricing. .
6 The Rationale for Risk Management

Let’s step back and ask ourselves a few existential questions:

• What is the rationale for risk management?

• Why do we want to manage the risk of firms (not necessarily financial

firms)?

How do we answer the standard corporate finance objection: ‘as long as

there is market transparency (the third Basel Pillar), investors can decide
themselves how much risk they are willing to accept, and can create the
portfolio they prefer’.
• Why do we want to manage the risk of banks?

Perhaps there is no reason to manage the risk of a widget-maker, but what

about managing the risk of a systemically important financial institution?
(Discuss externalities).
By the way, why should we look at banks differently? A few reasons:

• the externalities imposed by SIFIs on society (‘Too big to fail’);

• the implicit or explicit subsidies of systemically important financial institu-

tions enjoy.

Note: the existence of subsidies is not the same as the existence of exter-
nalities. There are two linked but different reasons why subsidized SIFIs
‘matter’, only one of which has a direct systemic dimension.
 • What is the relevance to the enforced risk management of the depositor
guarantee granted by government to systemically important deposit-taking
institutions. How can moral hazard be curbed?

• The ‘covenant’ between the government and the banks. [Discussion here]

How was this web of interests, subsidies and externalities reflected in the pre-
crisis regulatory framework?
7 The Risk Management Failure of 2007-2008
Revisited

7.1 Enlightened Self-Interest? (Greenspan 2007)

As we shall see, the conceptual framework that put market risk measurement
centre stage in the calculation of regulatory capital rests on the twin pillars of
enlightened self-interest, and the superiority of the private sector to come up
with the technology to capture, measure and manage risk.
Here is what Greenspan (2009) wrote:

"All of the sophisticated mathematics and computer wizardry es-

sentially rested on one central premise: that enlightened self interest
of owners and managers of financial institutions would lead them to
maintain a sufficient buffer against insolvency by actively monitoring
and managing their firms’ capital and risk positions."
The premise failed in the summer of 2007, leaving him "deeply dismayed."

The argument here seems to be that the enlightened self-interest of the pri-
vate decision-makers of subsidized, systematically-important institutions can
produce an outcome that is good for ‘everybody’ (shareholders managers of a
bank, taxpayers...)

Is this framework reasonable?

8 One Size Fits All?

Is it tenable that there should exist one ‘good’ form of risk management, inde-
pendent of who will use it?

If it did, then we should just go to the guys who can measure risk best (and
these were supposed to be the banks), and ask them to get on with it.

Is it really that simple?

Consider:
• Risk management from the perspective of the shareholders / the managers
of capital-regulated financial institutions.

• Risk management from the perspective of the shareholders / the managers

of non-capital-regulated financial institutions (for shadow banking, see The
End of Alchemy, Mervyn King, 2016).

• Risk management from the perspective of the regulators.

• Risk management from the perspective of the tax payers.

9 A Starting Point for the Analysis

How can we look in a unified manner at all these different perspectives of risk?

A common starting point in order to answer the question of whether a one-

size-fits-all approach to risk management is tenable can be the following: what
are the payoffs of these players?

• what is the payoff of the ultimate investor in (shareholder of) a capital-

regulated financial institution?

• what is the payoff of the manager of a capital-regulated financial institu-

tion?
• what are the payoffs of the investors / managers of a non-capital regulated
institution?

• what is the payoff of the regulator?

• what is the payoff of the taxpayer? [Discussion]

The first tentative conclusions that we can draw from this discussion are

• different economic agents are impacted by the failures of banks, and benefit
from the profits banks make, to very different extents and in very different
circumstances;

• it is therefore reasonable to expect that, even if they all agreed on the

magnitude and likelihood of profits and losses a bank faces (ie, even if
they all agreed on the measurement of risk — ie, on the outcome of what
we will learn how to do in this course), the risk management actions they
would take would be very different;

• externalities and subsidies play an important role in this differentiations of

responses to the same risky prospects.
10 Making the Intuition More Precise

As we have seen these payoffs are very different.

We have therefore concluded that it seems unlikely that such different payoffs
will give rise to identical responses to the management of systemic financial
risk.

How can we make this intuition more precise?

To make the analysis more precise we must specify

• the probability of achieving these payoffs;

• the monetary value of these payoffs in each state of the world (by the way,
1. and 2. is what traditional risk measurement is all about);

• the value (‘utility’) assigned by various agents to the monetary value of

these payoffs.
11 Utility Functions

There is a well-established theory of choice (under certainty and under uncer-

tainty) that provides a framework to answer these questions. It leads to the
idea of maximization of the expected utility.

If one had full confidence in this approach, all questions about risk (and reward,
and a lot more) would be answered by applying this formalism.
In reality the expected utility formalism has been subject to several different
sources of criticism, such as:

• it is correct in theory, but too difficult to ‘calibrate’;

• it is correct in theory, but not ‘intuitive’;

• it may be correct in theory, but this is not how people ‘really’ make choices
in reality;

• it is conceptually flawed.
We will not attack the problem of market risk management from the utility-
function perspective.

(We should ask ourselves, however, why is the idea of managing risk using EU
suspect, but the idea of doing so by looking at one percentile sound...)

However, EU provides a very useful tool to frame questions about risk, and
therefore we will take a brief look at what EU theory says.

We will not use the output of EU theory to get risk numbers out, but to help
our intuition.
12 Choice Theory : Risk Aversion in Rational
Choice Theory

In this section we want to understand how risk and reward are looked at in
finance theory: ie, through the prism of rational choice and utility theory.

To do so we have to specify how people make choices. We make some assump-

tions — some pretty innocuous, others less so.

We start from choice when there is no uncertainty.

Let A and B be two prospects or alternatives: eg, going to the beach, or
studying for the Market Risk Measurement course. We assume that

1. given any two prospects, A and B, we can always say whether we prefer
A (A ≻ B) or B (B ≻ A) or whether we are indifferent (A B).

2. given any three prospects, A, B and C, if we prefer A to B and B to C,

then we prefer A to C: if A ≻ B and B ≻ C =⇒ A ≻ C.

3. Continuity: If you prefer A to B, then adding to B a sufficiently small

amount ǫ of prospect C, cannot reverse the original preference:

if A ≻ B =⇒ A ≻ (1 − ǫ) B + εC (1)
(This mean that there are no cliffs in preferences.)
Under certainty we can say that

• If 1 and 2 hold, then it is possible to find a function, called a utility

function, u (x) : X → R, that takes in a prospect at a time and returns
a real number, and such that, if you prefer prospect A to prospect B, the
utility of A is greater than the utility of B:

if A ≻ B =⇒ u (A) > u (B) (2)

This is nice, but it only applies to the case of certain prospects.

What if the outcomes are not certain?

We can handle this, by introducing the concept of lottery.

Informally, we can think of a ‘lottery’ as an event with uncertain outcomes.

Tossing a coin for money is a lottery.

Buying equity stock is a lottery.

Starting a company is a lottery.

We assume that the probabilities, {π},associated with the uncertain

outcomes are perfectly known.
We also introduce the following additional axiom.

Independence axiom: Suppose that you prefer L1 to L2.

Then, for any other lottery L3,

L1 ≻ L2 =⇒

xL1 + (1 − x) L3 ≻ xL2 + (1 − x) L3 (3)

(Independence of irrelevant alternatives.)

Do you like these assumptions?

It is then possible to show that, under uncertainty, the choices made by a
rational, axiom-obyeing agent (Jenny) can be described as if she maximized
the expectation of the utility of the various outcomes.

So, if lottery LA has outcomes (L1A, L2A, L3A) with probabilities π 1A, π 2A, π 3A
and lottery LB has outcomes (L1B , L2B , L3B ) with probabilities π 1B , π 2B , π3B ,
then Jenny choices over lotteries can be described as if she first computed in
her mind
EU (LA) = π iAu LiA (4)
1=1,3
and
EU (LB ) = πiB u LiB
1=1,3
and then picked LA if the expected utility of LA, EU (LA), was greater than
the expected utility of LB , EU (LB ), and vice versa.
13 Adding Empirical Information

Nice as they are these results do not take us very far, unless we add some
empirical flesh to the beautiful but dry theoretical bones.

Now, people are supposed to like to consume ‘stuff’.

The more stuff they consume, the happier they are.

For a utility function to reflect this, then it should be increasing in consumption.

This means that if the certain prospects we input into the function U (x) are
consumption (money), then

U(c1) > U(c2) if c1 > c2

ie, the utility function must be increasing in consumption.

So, people like to consume.

However, that last ice cream never quite tastes as good as the first one.

We can model this by saying that people assign a ‘degree of pleasure’ (‘utility’)
to consumption that keeps on increasing with how much they consume, but
that does not increase one-for-one with the amount of consumption.

Again, the fourth slice of cake never tastes as good as the first.
How can we model this?

We need an increasing function that increases less and less rapidly.

A concave function such as the log or the square root function displays this
behaviour.

These two simple ingredients are enough to show that Jenny should be risk
averse.

What does ‘being risk averse’ mean?

That she will prefer a certain consumption to entering a lottery with the
same expectation.

Let’s see how a concave utility function implies risk aversion.

[Example here]
Figure 3:
In explaining risk aversion we have taken an expectation of the utility of the
lottery and compared it with the expectation of the utility of the sure thing.

This naturally leads to two related concepts:

• risk premium

• certainty equivalent
 0.15
Power utility function
0.05

-0.05 0.75 0.8 0.85 0.9 0.95 1 1.05 1.1 1.15

-0.15
risk neutr
tyil
it-0.25 Beta=0.25
u
Beta=0.5
-0.35
log

-0.45 Beta=2
Beta=4
-0.55 Beta=6

-0.65
consumption

Figure 4: Power utility functions for different values of the risk aversion coeffi-
cient. The limit for β → 0 corresponds to risk neutrality; ehe limit for β → 1
corresponds to the logarithmic utility function.
A risk premium, π, associated with a zero-expected-value lottery, ǫ, is the
amount of money you would be willing to pay to avoid entering the lottery.
[What can it depend on?]

So
u (c − π) = E [u (c + ǫ)] (5)

The quantity c − π is the certainty-equivalent level of wealth associated with

the lottery.

You are just as happy is your wealth decreases for sure by π or if you are forced
to enter the fair lottery.
In general, calculating the expected utility of a risky prospect is tantamount
to multiplying the utility corresponding to each different monetary outcome by
the real-world probability of that outcome occurring.

The real-world probabilities are usually referred to as the P-measure probabili-

ties.

[Concrete example of calculation]

Now we have a really powerful tool: a reasonable criterion for comparing (possi-
bly very different) risky prospects is to calculate and rank their expected utilities,
and choose the one with the maximum expected utility.

An important observation: the same expected utility could be obtained by

assuming zero risk aversion, and changing the real-world probabilities to new,
‘funny’ (risk-neutral) probabilities.

The associated risk-neutral probabilities are usually referred to as the Q-measure

probabilities. [Specific example]
14 An Example

Let’s take the power utility function as our starting point. This is given by
1 β
u (c) = c (6)
β

In the limit for β going to 1 this becomes a straight line, utility is the same as
wealth/consumption, and we have risk neutrality. [Why?]
Now, utility functions imply the same ordering of preferences up to a linear
transformation (ie, if we change u (c) into a + b × u (c). Therefore let’s
change the power utility function to
1 β 1 cβ − 1
u (c) = c − = (7)
β β β

Next, take the limit for β → 0.

cβ − 1
u (c) = lim (8)
β→0 β

Make a little substitution, and use the L’Hopital rule

cβ − 1 eβ log(c) − 1 eβ log(c) log (c)
lim = lim = lim = log (c) (9)
β→0 β β→0 β β→0 1
ie, the logarithmic utility function is the limit as β tends to 0 of the power
utility function.
With this under the belt, consider an agent whose wealth in some units is 1
today.

This agent is faced with a lottery that will increase her wealth to 1.25 with
probability 0.5 and will decrease her wealth to 0.75 with probability 0.75.

These probabilities are known with certainty.

What is the utility of the agent before entering the lottery?

Since we have chosen the logarithmic utility function u (1) = 0.

What is the expected utility, eu(bet), from entering the fair bet? We have
1 1
eu(bet) = u (0.75) + u (1.25) = −0.03227
2 2
This is less than the investor’s original utility, so she will not willingly enter the
bet.
Consider now the case of a risk-neutral investor, whose utility is given by the
limit for β going to 0 of
cβ − 1
u (c) = log (c) = lim
β→1 β

For the risk-neutral investor the expected utility of the lottery is the same as
the original before the bet:
1 1 1 1
lim (0.75)β + lim (1.25)β − = 0 = u (1) .
2 β→1 β β→1 β β
We can ask the question:

by how much does the ‘bad-state’ probability, p(bad), have to increase for the
expected utility of a risk-neutral investor to be the same as the expected utility
of the logarithmic-utility risk-neutral investor?
A quick calculation gives
1 1
p(bad) lim (0.75)β−1+[1 − p(bad)] lim (1.25)β−1 = −0.03227 =⇒
β→1 β β→1 β

p(bad) = 0.56454
We can call this probability the individual risk-neutral probability, or the individual-
Q-measure probability.
So, we have
 
Probabilities P-measure (real world) Q-measure (risk-neutral world)
 
 p (good) 0.5 0.43546 
p (bad) 0.5 0.56454
Note how the bad-state probability has increased under Q: Q-probabilities are
more pessimistic.
The important point is the following:

In making choices under risk, because of her risk aversion, a logarithmic-

utility player who knows the true probabilities acts as a risk-neutral in-
vestor who sees the ‘deformed’ probabilities.

The important take-away here is that when we make choices under risk
real-world probabilities get deformed.
15 The same example with a twist

Consider now two agents with the same logarithmic utility function, the same
real-world probabilities, but with the payoffs reversed: in the state where player
1 gets 1.25, player 2 gets 0.75, and vice versa.
 
Probabilities p (state 1) p (state 2)
 
 P layer1 0.56454 0.43546  (10)
P layer2 0.43546 0.56454

Now there now longer is a univocal ‘good’ and ‘bad’ state for everyone: there
are state 1 and state 2 instead: the state that is good for one player is bad for
the other.
We know already that in making choices about risk, true (real-world) proba-
bilities — the ones that risk measurement techniques strive to determine — tell
only a part of the story.

But the new point is that, even if all the agents affected by a set of outcomes
had the same aversion to risk and agreed on the real-world probabilities, the
difference in payoffs generate different ‘deformations’ of the subjective real-
world probabilities.

Both players would reject the fair bet, but, if allowed to improve their expected
utility by hedging (risk management), they would hedge against very different
things.

When diferent players have different pay-offs, there no longer is a univo-

cal ‘pessimistic’ direction in which real-world probabilities are deformed.
As a consequence, even if all agents have the same degree of risk aversion,
one set of agents cannot delegate the decision-making in conditions of
uncertainty to someone who happens to be good at calculating real-
world probabilities (as banks were supposed to be!), and hope that tje
outcomes of these calculations will be beneficial for everyone.
The example just presented of the good state for player 1 being the bad state
for player 2 and vice versa, is a bit contrived, but certainly the good states for
bankers do not coincide with the good states for taxpayers, and the bad states
for bankers are much worse states for tax payers.
Reconsider in this light the following.

• Does the enlightened self-interest argument make sense?

• What do you think will be the deformations of real-world probabilities by

the shareholders of a bank, its CEO, the head of risk management of the
same bank, a regulator, and the tax-payer — remember that they all agree
on the real-world probabilities?

• [Case study: the Head of Risk Management and the CEO looking at sub-
prime exposure of their bank in July 2007 .]

• So, who should make the risky decisions?

1. Remember the ‘covenant’: who was the covenant supposed to protect?

2. Remember the externalities: who is inflicting externalities on whom?

16 Different Measures for Risk Management — 1

16.1 Challenges to perfect rationality

There is a vast of body of literature that challenges the rationality assumption

("behavioural finance") and utility theory.

According to these critics, economic agents in general (investors, risk managers,

savers, etc) form a probability assessment of the world that differs from the
real-world P-distribution for reasons other than their risk aversion.

This subjective distribution is called the subjective (S-measure) distribution.

When asset prices are concerned, the proponents of the importance of irrational-
ity must always explain why rational and deep-pocketed arbitrageurs (read —
hedge funds, pension funds, insurance companies, etc), do not wash the irra-
tionalities away. ("Limits-to-arbitrage" literature, Shleifer & Vishny.)
In risk management, however, there is no ‘arbitrageur’.

As a consequence, there arguably is more scope for a probability distribution

of future events different both from the real-world P-distribution, and from the
pricing equilibrium-Q-measure distribution: the subjective (S-measure) distrib-
ution.
Nonetheless, traditionally ‘rational’ choice theory has taken the approach that
what gets deformed by risk aversion is the real-world ( P), not the subjective
( S) distribution of returns.

Novel interesting approaches are emerging to enrich this view (Hersh Shefrin,
Behavioural Risk Management, 2015), but it is too early to tell how fruitful
they will be.
17 Different Measures for Risk Management — 2

17.1 Do we need cognitive biases?

Important as the cognitive shortcomings of economic agents may be, the analy-
sis of subsidies, externalities and attaching payoffs should make clear that even
perfectly rational agents will take different risk management decisions once
faced with the same measurement real-world P-distribution of returns.

If, in addition, economic agents are also encumbered by ‘irrationalities’, then

the gap between risk measurement and risk management becomes even more
yawning!
But we do not need cognitive biases for a probability measure other than the
real-world one to be relevant for risk management.

To summarize: there are two distinct reasons why the real-world probability
distribution of outcomes may be deformed:

• one is linked to our risk aversion, and is totally compatible with a rational
(but not risk-neutral) economic agent — this is the P-to-Q transformation
alluded to above. Even if we learn to ‘think straight’ (ie, if we eliminate
our cognitive biases) these deformations will remain.

• the second brings into play cognitive deficiencies and various ‘errors’ in as-
sessing probabilities. [Example in class of overconfidence: the 10-question
game]
The deformations of the real-world probabilities caused by cognitive biases can
be severe.

According to some authors, in some contexts these biases cause the largest
deformations of the ‘true’ probabilities. However, as we have seen, even in
the absence of cognitive limitations and biases, each non-risk-neutral economic
agent will deform the real-world probability distribution in what is for her the
‘pessimistic’ direction.
And if the payoffs of various economic agents are different, the deformations
they impose to the real-world probability distribution will be very different.

Therefore decision-making cannot be easily delegated.

How is all of this reflected in the current regulatory framework — if at all?

18 The Conceptual Underpinnings of the Regu-
latory Framework

The unstated assumptions of regulatory capital approach based on modern

quantitative risk management:

• The underlying real-world (P) measure is knowable (same working assump-

tion as asset pricing);

• there are no systematic cognitive biases in the assessment of risky prospects:

(S = P);
• invoking the enlightened self-interest of private decision makers means that
the somehow the payoff of the entity (eg, the bank) to which the task of
calculating risk has been delegated will not affect the decisions made on
the basis of this assessment of risk;

• the managers of private financial institution can measure — and hence,

given their ‘enlightened self-interest’ and the perfect alignment of interests,
manage — financial risk better than regulators could;
• there is a near-perfect alignment of the interests of the managers of ‘banks’
and the ultimate owners;

• yet, despite their superior technical ability to measure and manage risk
, financial institutions should still be ‘goaded’ by ‘capital incentives’ to
embark in a sophisticated programme of risk discovery, quantification and
management;

• regulators should set standards for risk management, but not prescribe
how risk management should be carried out: again ,"private firms know
best".
19 A Quote

"I think we all agree that regulators should not manage the financial
risk of banks — banks should."

Gernot Stania, Head of Quantitative Risk Analysis Section, ECB — opening

statement of his address at the RiskMinds International Conference, Global
Regulatory Summit, 4th December 2017.

[Comment]
20 Why do enlightened firms need encourage-
ment?

Jorion (1997):

[T]he greatest benefit of VaR lies in the imposition of a structured

methodology for critically thinking about risk. Institutions that go
through the process of computing their VAR are forced to confront
their exposure to financial risks and to set up a proper risk man-
agement function. Thus the process of getting to VAR may be as
important as the number itself.
Questions:

• If private financial institutions are so ‘enlightened’ and are such centres

of excellence when it comes to measuring and managing risk, why did
they have to be ‘encouraged’ by the capital stick/carrot do devote (huge)
resources to the task in the first place?

• Why did they not do it of their own accord in the first place?

• How does all of this fit with the ‘enlightened self -interest’ of banks?
21 Stepping Back: Why VaR? What other mea-
sures of market risk ‘are there’ ?

Time to change topic. Whatever the deformations of the P-measure distribu-

tion of risk factors, in risk management practice very few people use the full
distribution of P&L. Instead, they distill from it some ‘measures’ of risk, of
which VaR is just one.

The historical account given at the beginning of this lecture of how VaR became
the risk-capital measure of choice from a regulatory perspective stresses the
almost serendipitous series of event that made VaR as a key tool to capture
and aggregate market exposure first, and to create a link.
This prompts the obvious question of whether there are other — and possi-
bly better — risk measures (understood as a mapping from a profit-and-loss
distribution to a single number ).

This in turns question prompts us to ask two questions:

• why do we need risk measures at all, if rational investors are utility max-
imizers? Why don’t economic agents just maximize their utility? [Same
utility functions for everyone?]

• If we still want to use a non-utility-based single-number risk measure, what

are reasonable properties required of something if we want to call it a ‘risk
measure’ ?
22 Why using risk measures at all?

22.1 The Case For and Against Expected Utility Maximiza-

tion

There are several reasons why risk measures are preferred to expected utility
maximization:

• Utility functions comes in many shapes and forms.

Despite this embarrassment of riches, no formulation of choice theory in

terms of utility functions is totally immune from conceptual problems.
• Even if we all agree on a functional form for a utility function, it is not
easy to calibrate it over a large range of possible outcomes — or even at
all.
• For all its technical rigour, the expected-utility approach does not have a
great intuitional appeal: when it comes to risk, we would like a number
such that ‘when the number is big, risk is big ’.

Utility theory does not (directly) gives us this.

• Pragmatically, the expected-utility approach does not directly lend itself to

the determination of capital.
23 Properties of a Reasonable Risk Measure

23.1 What Should the Inputs and Output be for a Reason-

able Risk Measure?

Given the discussion above — given, that is, that we do not want to go down
the utility maximization route — and given that we have assumed that we know
the probabilities attaching to all the possible outcomes for these portfolios, we
would like to use a risk measure instead. What properties should a desirable
risk measure enjoy?
A reasonable risk measure should have the following properties:

• we would like to associate a risk number to portfolios made out of risky

(and riskless) assets;

• keeping the real-world probabilities as ‘known background’, we would like

to get this risk measure by plugging the characteristics of our portfolio of
interest into a suitable risk function(al) and by getting out a real number;

• this number should give us an indication of risk.

24 A Class of Reasonable Risk Measures

24.1 Monetary Risk Measures

Suppose that we have a fixed set, Ω = {ω1, ω2, ..., ωn}, of possible market
outcomes, and a number of possible portfolios, z ∈ Z.

We want to make sure that a combination of portfolios is still a portfolio.

(Formally we can say that Z is a real linear vector space, but we don’t nee to
go into that.)
Suppose that we can associate to each portfolio, z, its discounted values, {x},
one for each possible market outcome: x = x (z; Ω) .

Each discounted value depends on the market outcome, ω.

Since az1 + bz2 is still a portfolio, say, z, we can put into the function x also
the composite portfolio az1 + bz2, because
 
 
x az1 + bz2; ω = x (z; ω) (11)
z

Next, consider a function, ρ, associated with the known set of possible market
outcomes, that takes in one or more portfolios, transforms these input portfolios
into their (discounted) payoffs, x (ω), and returns a real number.
So, take portfolio z. The function(al) ρ takes in z, first transforms it ‘internally’
to its payoffs, x (z1; Ω), in all the possible states of the world, and, from all
these numbers, returns a ‘risk number’ ρ (z):

ρ (z) = ρ (x (z1; Ω)) (12)

If the portfolio is made up of subportfolios, az1 + bz2,this is how the function

ρ operates:
  
  
ρ = ρ x az1 + bz2; Ω = ρ (x (z; Ω)) (13)
z
So, the background set of possible states of the world is fixed, the portfolios
vary, and the function ρ is a function of the variable portfolios evaluated against
the fixed background of states, ω.

Any function that does all of this is called a monetary measure of risk.
24.2 Properties of Coherent Risk Measures

What we have asked so far of this risk function is too vague, however, to be of
much use.

What properties should we ask of the monetary measure of risk function, ρ, for
it to reflect our intuition about the risk of a portfolio?

As an answer to this question, Artzner et al put themselves in the shoes of a

regulator, and asked themselves the question:

How should one define monetary risk measures in such a way that
we can define which risk we should accept or which we should reject?
This is what they came up with.

• no-position-no-risk principle: ρ (0) = 0 : this principle just sets the zero

reference point for the function.

• sub-additivity: ρ (Z1 + Z2) ≤ ρ (Z1) + ρ (Z2): diversification cannot

increase risk;

• positive homogeneity: ρ (αZ) = αρ (Z): doubling the size of your port-

folio doubles the risk;

• translational invariance: for a deterministic portfolio, A, with certain

return, a, (cash), ρ (Z + A) = ρ (Z) − A: adding certain cash to the
stochastic return of portfolio Z reduces its risk by the amount of cash.
If the functional ρ enjoys all these properties, it is said to be a coherent risk
measures.
25 Acceptance Sets

All monetary measures of risk generate the set of input portfolios (of positions)
which are acceptable (say, to a regulator).

More precisely, the acceptance set is the set, ΩZ , of all positions such that
ρ (Z) ≤ k (14)

Coherent risk measures are supposed to generate acceptance sets that make
good sense for a regulator.

By looking at coherent risk measures from the acceptability lens, we can also
understand better now the translational invariance condition: adding cash does
not decreases the uncertainty associated with a portfolio, but increases the
acceptability of the portfolio.
26 Stochastic Dominance

If we want to decide whether we should prefer Portfolio A or Portfolio B using

a utility function (for instance, by looking at the expected utility of the two
prospects), the ordering can change depending on the choice of utility function.

Are there criteria of choice between two portfolios that use the expected-utility
framework in a model independent way?
Answering this question leads to the concept of Stochastic Dominance. The
definition first.

If, for any increasing utility function,

E [u (A)] ≥ E [u (B)] (15)

then portfolio A first-order stochastic dominates portfolio B:

A F SD B (16)

Consider now the probability distribution of the losses, x, associated with Port-
folio A and Portfolio B. One can easily show that this condition is satisfied
iff
ΦA (x) ≤ ΦB (x) (17)
 1.2

0.8

0.6

0.4

0.2

0
-6 -4 -2 0 2 4 6

Figure 5: First order stochastic dominance

This is what this condition implies:

 0.45

0.4

0.35

0.3

0.25

0.2

0.15

0.1

0.05

0
-6 -4 -2 0 2 4 6

Figure 6: First order stochastic dominance

First-order stochastic dominance is nice, but rarely met in practice — after all,
what we have described is very close to the definition of arbitrage!

Can we do something a bit more ‘biting’ ?

This is where second-order stochastic dominance comes in.

Here is how it works.

Consider these two alternatives

1. Portfolio X: gain $180 with certainty;

2. Portfolio Y : gain $100 with probability 0.5 and $200 with probability 0.5

Which portfolio would you choose?

[Discuss]
Now suppose that your utility function is always increasing and concave (ie,
u (x) is a concave function of x). I know nothing else about your utility
function. (So, I know that you like more to less, and that you are risk averse -
aren’t we all?)

Remember that, for a convex function, f (x),

f (x + ǫ) + f (x − ǫ)
f (x) <
2

Then we have
1
E [u (X)] = E [u (180)] ≥ E [u (150)] ≥ (E [u (200)] + E [u (100)]) = E [u (Y )]
2
(18)

This make sense.

However, the distributions of the two portfolios do not satisfy first-order sto-
chastic dominance:
 1.2

0.8

0.6

0.4

0.2

0
0 50 100 150 200 250 300 350

Figure 7:

What can we do?

One can show that, any risk averse, non-satiable investor will always prefer
prospect A to prospect B iff
x x
A SSD B ⇐⇒ ΦA (t) dt ≤ ΦB (t) dt
−∞ −∞

This is what this implies:

 5
Integral 4.5
of cumulative
4
3.5
3
2.5
2
1.5
1
0.5
0
-6 -4 -2 0 2 4 6

Figure 8: Second order stochastic dominance

It turns out that if A Second-Order Dominates B, then the distribution func-

tions intersect only once and its cumulative distribution is below the cumulative
of B to the left of the intersection point.

However, the reverse is not necessarily true:

 1.2
Cumulative
1

0.8

0.6

0.4

0.2

0
-6 -4 -2 0 2 4 6

Figure 9: Second order stochastic dominance

 1.2
Cumulative
1

0.8

0.6

0.4

0.2

0
-6 -4 -2 0 2 4 6

Figure 10: Failure of second order stochastic dominance

27 What do we need to calculate a risk mea-

sures?

Stochastic dominance is theoretically nice but rarely sufficently ‘biting’ to give

actionable risk management suggestions.
 6
Integral of cumulative
5

0
-6 -4 -2 0 2 4 6

Figure 11:
Prcatitioners perfer to use risk meansures — ie, "risk numbers".

What do we need to calcualte risk measures?

27.1 The centrality of the joint pdf of risk factors and the
profit-and-loss distribution

Whichever measure of risk we want to use, we need to know

• which possible values our portfolios can assume over the set Ω;

• the probabilities attaching to the elements in Ω.

Since we have an infinite number of possible portfolios, we need

• a joint probability distribution of the (possibly very large, but finite) number
of risk factors that can affect the value of each of our portfolios;

• a mapping from each of these joint realization to the value (P&L) of our
portfolio. This is our first essential requirement.
So, the plan of action is to obtain a univariate distribution of profit and losses
from the impossibly high-dimensional joint distribution of risk factors

The tasks head of us are therefore:

• an accurate mapping from any joint realization of the risk factors to the
value of the portfolio of interest;

• the calcuation of the univariate probability distribution for our portfolio;

• the use of this univariate probability distribution to get the risk measure
of our choice (or the value of utility).
28 How does the univariate P&L distribution gets
manipulated?

Different risk measures ‘take in’ and ‘do different things’ to the P&L probability
distribution. For instance:

• VaR picks up just a percentile from the P&L distribution — extremely

wasteful!

• Conditional expected shortfall calculates the average ‘in the tail’ (ie, past a
given percentile). We use more information, but only in the tail. Since we
are only looking at information in the tail, it goes without saying that we
cannot say anything about risk/reward trade-offs. The strategic decisions
on investments are made on another floor.
Figure 12:
• Utility maximization takes into account every little bit of the full distribu-
tion. One can ask questions about risk/return trade-offs. Pity that only a
selected breed of financial professionals likes it!
29 A last word of caution

Just because a risk measure is ‘coherent’ or ‘convex’ it does not necessarily

mean that it makes a lot of sense to base our risk decisions based on the value
of this measure.

For instance, as we shall see, the Conditional Expected Shortfall is coherent.

But why exactly should we make risk choices based on the average of the losses
past the 98% percentile? why not the 99%? or the 90%?

So, perhaps we should consider the conditions for coherence or convexity as

necessary for a functional of portfolio outcomes to be useful as a risk functional,
but certainly not as necessary and sufficient conditions.
30 Some Mathematical Background*

30.1 The Ornstein-Uhlenbeck Process

Consider the following continuous-time process (which is known as the Ornstein-

Uhlenbeck process, or as a mean-reverting diffusion process, or, more compactly,
as a mean-reverting diffusion):

dxt = κ (θ − xt) dt + σdzt , (19)

mean-reverting term stochastic term
with dzt the time-t increment of a Brownian motion. We discuss the properties
of mean-reverting diffusion process in Chapter 8. For the moment we simply
note that Equation (19) ‘says’ that a variable, xt, is attracted to its reversion
level, θ, with a strength that is proportional to a reversion-speed strength (the
quantity κ), and to how distant the variable is from its reversion level (the
quantity (θ − xt)). Absent the stochastic term, σdzt, the quantity xtwould
approach monotonically and exponentially its reversion level, θ. It is the expo-
nential term that allows moves away from the reversion level, and the ‘crossing’
of the reversion level.

We can discretize the process (19) as

√
xt+1 − xt = κθ∆t − κxt∆t + σ ∆tǫt =⇒
√
xt+1 = κθ∆t + xt (1 − κ∆t) + σ ∆tǫt (20)
with
ǫt˜N (0, 1) (21)
As we shall see in the next sub-section, this discretization shows clearly the
parallels between an Ornstein-Uhlenbeck process and a simple autoregressive
(AR(1)) process. See below.

A few words on the volatility, σ. Since we almost invariably deal with Gaussian
models, the volatilities are ‘absolute’ or ‘normal’ (not percentage) volatilities.
So, we write a volatility as σ r = 0.0120, never as σr = 1.2%. As for yields, we
often refer to one hundredth of a 0.01 volatility as a ‘basis point volatility’. So,
we sometimes say ‘the volatility of the short rate is 120 basis points’ instead of
writing σr = 0.0120. The important thing to remember is that, whatever units
we may want to express volatilities in, they will always have the dimensions of
3
[$] [t]− 2 . This would not be the case if we used a different (but still affine)
model, such as the one by Cox, Ingersoll and Ross (1985a, 1985b).

Suppose now that the time-t value of the process is xt, and that this value does
not coincide with the reversion level, θ . If we neglect the stochastic term, how
quickly does the process halve its distance to θ? It is easy to show (see Chapter
8) that the ‘half life’, H(κ), (as this time is called) is given by
log 2
H(κ) = . (22)
κ
In arriving at this result we have neglected the stochastic term, ie, we have
assumed that the process (19) was actually of the form

dxt = κ (θ − xt) dt. (23)

One can show that one obtains the same result if one deals with the full process
(19), but one is interested in the expected time for the distance |θ − xt| to be
halved.

Exercise 1 Prove this result.

30.2 The AR(1) Process*

Let’s now move to discrete time, and let’s consider the trusted work-horse of
time series analysis, the autoregressive, order-1, AR(1), process

xt+1 = µ + xtφ + νηt+1 (24)

with
ηt+1˜N (0, 1) . (25)

Note that Equation (24) is just a regression, with the values of the variable at
time t as independent variables (the ‘right-hand’ variables) and the values of
the variable at time t + 1 as the dependent variables (the ‘left-hand’ variables).
Then φ is the slope and µ the intercept.
The parameter φ is important, because it determines the stability of the process:
if |φ < 1|, the system is stable, and the further back in time a disturbance has
occurred, the less it will affect the present. Random walks are a special case
of this, where φ = 1: yesterday’s increment does not affect in any way today’s
increment. Full memory is therefore retained of any shock that occurred in the
past. As the shock ‘persists’ (in expectation), an AR(1) process with φ = 1
is said to be persistent.

If |φ > 1| the system is unstable, which is a less scary way to say that it blows
up.

One can show that the (theoretical) mean, m, of the AR(1) process xt is given
by
µ
m= , (26)
1−φ
its (theoretical) variance, V ar (xt), is given by
v2
V ar (xt) = 2
(27)
1−φ
and that the (theoretical) serial correlation, corrn, between realizations n pe-
riods apart is given by
corrn = φn. (28)

Finally, for future reference we state without proof that the time-t expectation
of the process xt i steps ahead of time t, Et [xt+i], is given by
1 − φi
Et [xt+i] = φixt + µ (29)
1−φ

Exercise 2 Derive Equation (29) and show that it coincides with Equation (26)
when the time i goes to infinity.
30.3 Parallels between AR(1) Processes and the Ornstein-
Uhlenbeck Process*

With these properties and definitions under the belt, we can establish a par-
allel between a discrete AR(1) process and the discrete-time versions of the
continuous-time mean-reverting process (19). We go back to the discretization
the Ornstein-Uhlenbeck process obtained above:
√
xt+1 = κθ∆t + xt (1 − κ∆t) + σ ∆tǫt.
Comparing this expression with the definition of a discrete-time AR(1) process,
this means that a discretized Ornstein-Uhlenbeck process is just a special
AR(1) process with
µ = κθ∆t (30)
 φ = (1 − κ∆t) (31)

ν 2 = σ2∆t (32)

Given a time series (xt) the parameters of the AR(1) process can be estimated
by regressing the left-hand variable (the ‘y’ variable), xt+1, against the right-
hand variable (the ‘x’ variable, the regressor), xt. Once again, the independent
variable (the regressor) is the lagged left-hand variable: the intercept will give
µ, and the slope will give φ.

In principle, using Equations (30) to (32) we can then relate the regression
slope, the intercept and the variance of the error to the parameters of the
mean-reverting, continuous-time process, (19). In practice, this brute-force
approach usually requires some tender loving care before it can be made to
yield reasonable results, but we won’t go into this here.
In the rest of the book we will eclectically and opportunistically move from the
continuous-time and the discrete-time (AR(1)) formulations of a process so as
best to serve our needs.
31 Appendix 3 — Some Results from Stochastic
Calculus*

We present without proof some results from stochastic calculus that we will
use when we switch from a discrete-time to a continuous-time treatment. For
those readers who do not like seeing rabbits being pulled out of hats, a non-
scary introduction to stochastic calculus is given in Klebaner (2005). And for
those more demanding readers who do not want to take any shortcuts, and for
whom only the best will do, Karatzas and Shreve (1988) is the place to go. It
is so good, that one day I will finish it myself.
31.1 Ito’s lemma

Suppose that a stochastic variable, xt, follows the following process:

dxt = µ (xt, t) dt + σ (xt, t) dzt, (33)

where dzt is the increment of a Brownian motion: E [dzt] = 0 and var [dzt] =
dt. Purists will say that Equation (33), which is often referred to as a Stochastic
Differential Equation, is just a short-hand notation, because only the equivalent
integral form (the Ito integral) is properly defined. However, for our purposes
it will do just fine.

Consider now a function, yt, of the stochastic quantity, xt, that evolves ac-
cording to Equation (33): yt = f (xt). Let’s assume that the function f (xt)
can be differentiated twice with respect to xt and at least once with respect to
time. What will the process for the variable yt look like?
Ito’s lemma gives us the answer: given the process for the state variable in
Equation (33), the process of the new variable, yt, will have the following form:
∂yt ∂yt 1 ∂ 2yt 2 ∂yt
dyt = + µ (xt, t) + 2 σ (xt, t) dt + σ (xt, t) dzt. (34)
∂t ∂xt 2 ∂xt ∂xt

For readers who are familiar with ‘traditional’, but not stochastic, calculus, the
1 ∂ 2yt 2
only surprising term is the ‘convexity’ term 2 2 σ (xt, t).
∂xt

What if the ‘new’ variable, yt, had bee a (twice-differentiable) function of n

variables, xit, i = 1, 2, ..., n? The Ito’s lemma generalizes as follows:
 
∂y ∂y 1 ∂ 2y ∂yt
 t t t  i,
dyt = + i
µ (xt , t) + σ i σ i ρij dt + σ i dz t
∂t i ∂xt 2 iij ∂xit∂xjt i
i ∂xt
(35)
where ρij denote the correlations between the ith and the jth state variable.
31.2 Stochastic-Calculus Rules for dptdxt

With respect to the one-dimensional case, the only significant difference in

Equation (35) comes from the terms σ iσi ρij . Where do these correlations
come from?

To understand their origin, consider two diffusive stochastic processes, xt and

pt. Let the process for a second quantity, pt, be given by:

dpt = µp (pt, t) dt + σp (pt, t) dwt. (36)

Here dwt is the increment of another Brownian motion, correlated with degree
of correlation ρ with dzt. Sometimes (for instance when we calculate variances
or correlations), we may want to calculate the product dxtdpt:
 dptdxt =

[µx (xt, t) dt + σx (xt, t) dzt] µp (pt, t) dt + σp (pt, t) dwt .

When we take expectations, the following heuristic rules are then useful to keep
track of the order of differentials:

dtdt = 0 (37)

dzdt = 0 (38)

dzdw = ρdt. (39)

So, the correlations ρij in Equation (??) come the product of stochastic terms
of the form σidzti σj dztj . As anticipated, we will use these relationships
when we calculate the covariance between two processes of the type (33). For
instance, by using the cheat sheet of Equations (37) to (39), we immediately
obtain for the covariance between the two processes:

cov dx1t ,dx2t ≡ E dx1t dx2t =

E µ1 (xt, t) dt + σ 1 x1t , t dzt µ2 (xt, t) dt + σ1 x2t , t dzt =

σ1 x1t , t σ2 x2t , t ρdt. (40)

31.3 Expectations of Ito Integrals*

Another useful result is the following∗. Let’s integrate over time (from time t
to time T ) the diffusive process for xt. What we have is called an Ito integral,
ItT ,
T T
ItT = dxs = µ (s) ds + σ (xs, s) dzs. (41)
t t
Its value at time T is not known at time t, because it will depend on the path
followed by dzs from time t to time T . However its expectation is known at
time t, and is given by
T T
Et ItT = Et µ (s) ds + σ (xs, s) dzs = µ (s) ds (42)
t t
∗ See Kleber (2005), page 94.
because, for any σ (xs, s),
T
Et σ (xs, s) dzs = 0. (43)
t
31.3.1 The Normal Case

From this we can obtain some interesting results. Take a process, xt. If its
drifts and volatilities are of the form

µ (xt, t) = µ (t) (44)

σ (xt, t) = σ (t) (45)

(ie, they do not depend on the state variable), then the future, time-T , value
of the state variable, xT , given its value, xt, at time t is given by:
T √
xT = xt + µ (s) ds + σT
t T − tǫ (46)
t
with ǫ the draw from a standard normal distribution,

ǫ˜N (0, 1) (47)

and σT
t denotes the mean-square-root of the volatility:

1 T
σT
t ≡ σ2 (s) ds. (48)
T −t t
As for the (conditional) expectation of the process, E [xT |xt], from the result
above about the expectation of an Ito integral we have:
T
E [xT |xt] = xt + µ (s) ds. (49)
t
31.3.2 The Log-Normal Case

If the drifts and volatilities are instead of the form

µ (xt, t) = xtµ (t) (50)

σ (xt, t) = xtσ (t) (51)

then the process is called a lognormal or geometric diffusion and we can write
for it the following Stochastic Differential Equation:
dxt
= µ (t) dt + σ (t) dzt (52)
xt
drift stochastic term
which has a solution of the following form:
T 1 σ 2(s) ds T
µ(s)−
xT = xte t 2
e t σ(s)dzs . (53)
The expectation Et [xT ] is given by
T
Et [xT ] = xte t µ(s)ds (54)
because it can be shown that
T 1 2 T
− σ (s)ds
Et e t 2 e t σ(s)dzs = 1. (55)
31.4 The Ito Isometry

Finally, when we calculate variances over!a finite time span we

" are sometimes
led to evaluate expression of the type Et T σ (x , s) dz 2 . The following
t s s
result (Ito isometry) holds:
 
T 2 T
Et  σ (xs, s) dzs  = Et σ (xs, s)2 ds. (56)
t t

Note carefully: we started with the expectation of the square of the integral of a
stochastic quantity (the value of the path-dependent integral, tT σ (xs, s) dzs)
and we ended with the integral of the expectation of the square of the ‘volatility’.

If the volatility does not depend on the stochastic variable, σ (xs, s) = σ (s),
this gives
 
T 2 T
Et  σ (xs, s) dzs = σ (xs, s)2 ds (57)
t t

which says something even more amazing, namely that the time-t expectation
2
of tT σ (xs, s) dzs is a deterministic quantity, and that this quantity is just
equal to the ‘variance delivered’ from time t to time T . This property means
that there are no ‘lucky’ paths, and that, for a Brownian process, along each and
every path, no matter how short or how long, the variance is always known at
the outset. This is the property upon which replication strategies for derivatives
pricing are built, but we will not go into that.