MATLAB for Use in Finance

Portfolio Optimization (Mean Variance, CVaR & MAD)

Market, Credit, Counterparty Risk Analysis and beyond

Marshall Alphonso Marshall.Alphonso@mathworks.com

Senior Application Engineer
MathWorks

© 2013 The MathWorks, Inc.1

Agenda

 Introduction: Knowing your risk

 Overview of the MATLAB Solution

– Connect to financial data sources
– Perform financial modeling & analysis
– Share results & deploy applications

 Finance Application Examples

– Portfolio Construction using Frameworks
– Evaluating Risks
– Constructing your own Portfolio Management Framework

2
Challenges in Financial Analysis

Financial
 Volatile markets Engineer
Quant Group
– Ever-changing needs

 Lack of computing power

Traders
– Large data, large models Management

 Increased transparency Other groups

– More auditing and regulation

– More sharing with colleagues

Regulators Clients Partners 3

Challenges Faced During Model Development

Traditional Approach Challenge

Off-the-shelf software Inability to customize

Third-party consulting Lack of transparency

Subpar computational
Spreadsheets, Excel
speed, limited data size
In-house development with
Long development time
traditional languages
Inefficiencies in
Combination of the above
Integration & Automation
4
 Who uses MATLAB in Financial Services?

 The top 15 asset-

management companies

 9 of the top 10 U.S.

commercial banks

 12 of the top 15 hedge funds

 The reserve banks of all

OECD member countries

 The top 3 credit rating

agencies

5
Agenda

 Introduction: Knowing your risk

 Overview of the MATLAB Solution

– Connect to financial data sources
– Perform financial modeling & analysis
– Share results & deploy applications

 Finance Application Examples

– Macroeconomic modeling & forecasting
– Cash flow hedging & scenario analysis
– Credit risk assessment

6
Computational Finance Workflow

Access Research and Quantify Share

Files Reporting
Data Analysis
& Visualization

Financial
Databases Applications
Modeling

Application
Development
Datafeeds Production

Automate
7
Portfolio Optimization
-3
x 10 Efficient Frontier
3.5

Mean of Portfolio Returns

3

2.5

1.5

1
0.005 0.01 0.015 0.02
Standard Deviation of Portfolio Returns

Efficient Frontier
0.35
Mean of Portfolio Returns

0.3

0.25

0.2

0.15

0.1
0.005 0.01 0.015 0.02
Standard Deviation of Portfolio Returns

8
Modeling Market Risk Factor Time Series

Need model that captures:

 Correlation & overall volatilities
 Time-varying volatility
 Fat-tailed distributions

Candidate model: Geometric Brownian Motion

 Correlation & overall volatilities
 Time-varying volatility
 Fat-tailed distributions

9
Market Risk Using Copulas, GARCH & EVT
“Forecasting risk factors”
Need model that captures:

 Time-varying volatility GARCH

 Fat-tailed distributions Generalized Pareto

 Factor Correlations Copulas

10
Market Risk Using Copulas & Extreme Value Theory
“Asymmetric GARCH using a GJR Model”

 Model returns using a asymmetric GARCH Model

 Estimate a Marginal CDF – Kernel + Pareto Tails

 Fit a Student-T Copula and induce correlation amongst

the simulated residuals

 Estimate a VaR & CVaR

11
The GARCH Model
“Non-symmetric, Non-Gaussian residuals”

R M
yt  C   i yt i    j  t  j   t
AR i 1 j 1 ARMA
P Q
     Gi
t
2 2
t i   A j  t2 j
i 1 j 1

 t   t zt
zt ~ N (0,1) GARCH ARCH

12
 Credit Classification
“Logistic Regression Vs. TreeBagger”
Logistic: [Training Set] Actual Vs Estimated Credit Ratings
CCC 2.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 15.00%
B 1.43% 3.71% 2.29% 0.00% 0.00% 0.00% 0.00%
BB 0.00% 4.29% 16.29% 5.14% 0.29% 0.00% 0.00% 10.00%
BBB 0.00% 0.00% 3.71% 12.86% 3.71% 0.00% 0.00%
A 0.00% 0.00% 0.00% 1.71% 9.14% 4.00% 0.00%
5.00%
AA 0.00% 0.00% 0.00% 0.00% 2.86% 9.14% 1.14%
AAA 0.00% 0.00% 0.00% 0.00% 0.00% 1.43% 14.86%
0.00%
C

A
BB

AA
B

A
CC

BB

AA
Logistic: [Testing Set] Actual Vs Estimated Credit Ratings
CCC 2.65% 0.39% 0.00% 0.00% 0.00% 0.00% 0.00%
15.00%
B 1.09% 2.40% 1.06% 0.00% 0.00% 0.00% 0.00%
BB 0.00% 5.70% 17.06% 5.42% 0.03% 0.00% 0.00%
10.00%
BBB 0.00% 0.00% 3.07% 14.57% 3.38% 0.00% 0.00%
A 0.00% 0.00% 0.00% 2.21% 10.36% 1.62% 0.00%
5.00%
AA 0.00% 0.00% 0.00% 0.00% 2.18% 10.16% 1.01%
AAA 0.00% 0.00% 0.00% 0.00% 0.00% 1.76% 13.90%
0.00%
C

A
BB

AA
B

A
CC

BB

AA
>> doc mnrfit Popular in classifying the credit quality of instruments is the use of logistic
>> doc mnrval regression. This example illustrates this classification but takes a step
>> doc treebagger further by using a Tree Bagger classifier.
>> doc confusionmat
13
Credit Value Adjustment – Expected loss on portfolio


Yield Curve Evolution

0.1

0.08
Rates

0.06

0.04

Jan15 300
Jul12 200
Jan10 100
Jul07 Tenor (Months)
Observation Date
[Section 3|EX 1] 14
Evaluate Counterparty Exposures


>> doc IRDataCurve

>> doc hwv
CVA for each counterparty
6000

5000

4000
CVA $

3000

2000

1000

0
1 2 3 4 5
Counterparty

[Section 3 | EX 1] 15
 Connect to Data from Various Sources

 Excel spreadsheets and flat

files

 ODBC or JDBC compliant

databases

 Data feeds including

Bloomberg, Reuters,
Factset®, eSignal® and
others

 Web services (SOAP)

16
 Leverage Built-in Functions to Save Time

Mathematics
 Regression (Linear, Non-Linear)
 Curve Fitting
 Probability Distributions, RNG
 Clustering
 Multivariate & Factor Analysis
 Predictive Modeling, AI
 Optimization, Parameter Estimation

Financial Modeling
 Portfolio Optimization & Analysis
 Derivative Pricing & Hedging
 Yield Curve Modeling
 Monte Carlo Simulation
 Risk Quantification
 ARMA/GARCH Analysis

17
Sharing MATLAB Applications

MATLAB

MATLAB MATLAB
Compiler Compiler SDK

MATLAB
MATLAB .exe Excel
Hadoop Production
C/C++ Java .NET
Server

 Share applications with those who do not need MATLAB

 Royalty free

 MATLAB Production Server provides most efficient path

for secure and scalable enterprise applications
18
Financial Modeling Workflow

Access Research and Quantify Share

Files
Files Data Analysis and Visualization Reporting
Reporting
Databases Data Analysis
Financial Modeling Applications
& Visualization
Datafeeds Application Development Production

Financial
Databases Applications
Modeling

Spreadsheet Link EX Financial Instruments Econometrics

Report Generator
Production Server

Database Financial
MATLAB Compiler
Application SDK
Datafeed Statistics & Machine
Development Optimization
Datafeeds Learning Production
MATLAB Compiler
Trading

MATLAB

Parallel Computing MATLAB Distributed Computing Server

Automate
19
 Deploying MATLAB Applications to Excel

3
Toolboxes

1 MATLAB End-User
Desktop Machine

MATLAB Compiler
2
MATLAB
Builder EX

.bas/
.dll .xla

20
Production Deployment Workflow
Development MATLAB Algorithm
Developer

MATLAB
Compiler

CTF
Enterprise
Application Web
Developer Application MATLAB Production Server

Client Function Call

Library

Production
MATLAB Production Server
Web
.. Application
.
Client
Library

21
 Value of MATLAB Production Server

 Directly deploy MATLAB programs into production

– Supports multiple MATLAB programs and MCR versions

 Scalable & reliable MATLAB Production Server(s)

– Service large numbers of concurrent requests
– Add capacity or redundancy with additional servers

 Use with web, database & application servers HTML

XML
– Lightweight client library isolates MATLAB processing Web
Java Script
Server(s)

22
 CAMRADATA Models Dependencies for
Quantitative Risk Assessment with
MathWorks Tools

Challenge
Rapidly develop quantitative tools for factor analysis,
risk analysis, and defensive asset allocation Risk-assessment model developed in
MATLAB.
Solution
Use MATLAB to model complex non-linear dependencies
between assets, liabilities, and economic variables using
copulas
Results
 Development time reduced by 90 percent “Using MATLAB we can build a
 Risk calculated in hours, not weeks model in one morning. It would
 Diverse skill sets leveraged
take two weeks to write the
equivalent code in Visual Basic.”
Martyn Dorey
CAMRADATA

Link to user story

23
 Capgemini Helps Clients Achieve Basel II
Compliance and Deliver Economic Capital,
Risk, and Valuation Models with MATLAB

Challenge
Enable banking clients to meet Basel II regulatory
guidelines and perform other risk management tasks
Scatterplots showing 500,000 simulations
drawn from bivariate t-copulas with the same
Solution correlation coefficient but differing degrees
Use MATLAB to develop risk management models and of freedom.

to perform valuations of complex products

Results
 Strong competitive advantage established
 Scalable solution delivered
 Customer portfolio revalued
“With its computational power, matrix
infrastructure, and ability to perform
Monte Carlo simulations, MATLAB gives
us a competitive advantage in
performing complex risk analyses."
Dr. Marco Folpmers
Capgemini

Link to user story

24
 Intuitive Analytics Uses MATLAB to Build
Quantitative Tools to Help Bond Issuers
Manage Risk

Challenge
Build and market a quantitative tool for reducing Using MATLAB technical computing
software to provide visual representations
expected cost and risk for municipal bond issuers of interest rate models.

Solution
Use MathWorks tools to develop algorithms, visualize
results, and simplify deployment of an advanced
analytical tool
“Because MATLAB enables us to
Results build and distribute applications to
 Development productivity increased by 90%
analysts that are accessible from
 Deployment simplified
Excel, we are quickly bringing to
 Visual environment created
market products that are adopted
and deployed by investment banks.”
Peter Orr
Intuitive Analytics

Link to user story

25
 IPD Develops and Deploys Real
Estate Cash Flow Models with
MathWorks Tools 25%
20%
15% '06
10%
5% '07
0%
'08
2
Challenge 4 6 8 10 12 14 16 18
Create cash flow models of real estate investment 0-0.05 0.05-0.1 0.1-0.15 0.15-0.2 0.2-0.25

portfolios and project returns using Monte Carlo MATLAB graph generated to indicate how total returns
simulations from industrial property are likely to behave.

Solution
Use MATLAB and MATLAB Builder NE to develop “The only other approach we
optimization algorithms, build financial models, and seriously considered involved
deploy solutions developing a class library in
Results .NET and C#. Development,
 Development time cut by 16 weeks debugging, and testing would
 Updates completed in hours have taken us 37 weeks. Using
 Deployment simplified MATLAB, we completed the
project in 21 weeks.”
Peter McAnena
Investment Property Databank
Link to user story

26
 Nykredit Develops Risk Management and
Portfolio Analysis Applications to Minimize
Operational Risk
Challenge
Enable financial analysts to make rapid, fact-based
decisions by providing them with direct access to risk
management and portfolio analysis information
Solution
Develop and deploy easy-to-use graphical financial
analysis applications using MATLAB and MATLAB
Compiler
Results
 Productivity increased threefold
 Operational risk mitigated
 Analysis time reduced from days to hours
Link to user story
Nykredit’s tool for calculating and
visualizing risk statistics. The plot
shows portfolio expected tracking
error broken out by industry.
“Data handling, programming, debugging,
and plotting are much easier in MATLAB,
where everything is in one environment.
For performance calculation GUIs,
MATLAB provides a real error-checked
application that makes cool customized
plots for client reports. This has turned a
several-hour task in a spreadsheet into a
two-minute no-brainer.”
Peter Ahlgren
Nykredit Asset Management
27
 Macroeconomic Modeling and Inflation
Rate Forecasting at the Reserve Bank of
New Zealand

Challenge
Support New Zealand monetary policy with a
Sample fancharts produced by RBNZ’s
theoretically well-founded model macroeconomic model.

Solution
Use MATLAB to analyze and forecast macroeconomic
variables, and communicate results to stakeholders
Results
 Entire workflow completed in a single environment “With all RBNZ models now
 Code shared with other central banks and implemented in MATLAB, the
financial institutions RBNZ has a common platform
 Technical rigor of macroeconomic forecasting for evaluating the economy and
increased making informed decisions.”
Jaromir Benes
International Monetary Fund

Link to article
28
 Robeco Develops Quantitative Stock
Selection and Portfolio Optimization
Models with MathWorks Tools

Challenge
Develop, distribute, and maintain quantitative
tools for portfolio construction and management
Interest rate paths for the risk analysis of a
Solution savings product.

Use MATLAB and MATLAB Builder NE to develop

algorithms, build quantitative models, and deploy
solutions
Results
 Applications updated faster
 Black-box solutions eliminated
 Scalability and flexibility increased
Link to user story
“Unlike companies that rely on off-the-
shelf quantitative analysis solutions, we
can see our process improving all the
time. We have the flexibility to
continuously improve our algorithms
and models in MATLAB—and that is a
big advantage.”
Willem Jellema
Robeco

29
MATLAB Solutions

Challenge Solution
Flexible modeling
Inability to customize
 Complete development environment

White-box modeling
Lack of transparency
 Viewable-source functions

Subpar computational Powerful computation engine

speeds  Run fast Monte-Carlo simulations

Quick prototyping
Long development time
 Focus on modeling not programming

Inefficiencies in Easy to Integrate & Deploy

Integration  Point-and-click workflow

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Questions

31