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Pricing model validation and process review 
22th, September2014 
Stephane Eyraud 
seyraud@chappuishalder.com 
Benoit Genest 
bgenest@chappuishalder.com
2 
Pricing & Validation key issues 
Approach 
Appendixes 
CH&Cie presentation: risk management offer 
Agenda 
1 
2 
3 
4
3 
Finance delegates to CIB Finance the supervision of the entire P&L and valuation control process 
CIB Finance responsibility is carried out through “CIB Financial Control” and the coordination of the governance structure 
CIB Financial control is a “global” finance control function which is responsible for supervision of the entire Valuation and P&L Control framework (which includes 1st and 2nd level controls) across capital market activities, global coordination (prepares and drives the monthly Committees that examine all issues relating to valuation, P&L and system booking) 
The responsibility is shared by many players, each of them is responsible for their respective perimeter 
Operations 
Front Office 
Risk 
Finance 
Middle Office & Product control 
Back Office 
Global Finance 
Headquarter 
Global Finance Control 
CIB Local Finance 
Global Finance Control 
Local 
1 
2 
3 
4 
Based on the charter of responsibilities, which defines the breakdown of responsibilities on the valuation and P&L controls, the organization is placed under the supervision of the Finance function 
Finance guarantees the production and the quality of the Group financial statements and Group Management accounts 
Finance uses to delegate the production and control of the financial instruments’ fair value, to the various participants 
Finance delegates to Risk the authority to control the fair value of the financial instruments booked in the Group accounts (models, parameters) 
Market Supervision and validation: a complex control frameworkGeneral Overview: Functional organization & delegation principles
4 
Ensurecorrectrepresentationofoperationsintheofficialsystems 
Determinethemarketparameterstobeusedandensuretheirdailycontribution 
Contributetotheobservabilityassessmentwork 
Proposemodificationstothemodelsandvaluationmethodologies 
Supervisemodelimplementationwork 
ContributetotheeconomicP&Lvalidation 
AreresponsiblefortheimplementationoftheFOsystemsthataresecureandthatfulfilthecontrolobjectives. 
Front Office 
Finance 
Operations 
Risk 
Define the adequate economic valuation methodologies and establish a reserve policy covering model, parameter and liquidity risks 
Approve and review the models used by the Front Office 
Draw up and maintain the “models/products” mapping 
Contribute to the controls over deal representation in the systems, when no booking rules have been set 
Have authority over the observability status of market parameters and products 
Are directly responsible for the control of the non- standard market parameters, and are responsible for assisting Operations in the implementation of the standard parameter controls 
Determine reserves. 
Ensurethatthedealrepresentationintheofficialsystemsarecompliantwithasetofpre-definedrules 
EnsurethattransactiondetailsbookedbytheFOthatimpacttheeconomicrevaluationareproperlyreconciledwiththecontractualterms 
Validatethe“standard”marketparameters 
Contributetothereservescalculationprocess(undertheresponsibilityofRCM) 
Produce,analyseandvalidate(substantiate)theofficialP&L 
ContributetothereconciliationbetweentheaccountingP&LandtheeconomicP&L 
ContributetocalculationoftheDayOneP&Ladjustments 
Ensuretheaccurateprocessingofoperations(i.e.clearingandsettlement,paymentandcashmanagement,confirmations) 
Performoperationalcontrols(i.e.resolutionofunsettleddeals,reconciliationofcashandsecuritiesmovementswithclearer/custodian/broker) 
Middle Office & Product Control 
Back Office 
EnsurethesupervisionoftheentireValuationandP&LControlframework(firstandsecondlevelcontrols)throughtheconsolidationandanalysisofthereportsreceivedfromallthecontributorstotheValuationandP&LControlChain 
Prepareandcoordinatethemonthlyandquarterlymeetings. 
Coordinatethegovernancestructure,namelymonthlyP&Landquarterlyexecutive 
Headquarter 
Local 
PerformthefirstlevelcontrolsthatarewithintheFinancearea,notablyaccountingcontrols; 
PerformthereconciliationbetweenaccountingandeconomicP&Ls, 
Assumetheentity-specificpartofthe“CIBFinancialControl”supervisionmandate 
1 
2 
3 
4 
Market Supervision and validation: a complex control frameworkFocus on mission statements (Key responsibilities)
5 
Front Office 
BackOffice 
Finance 
Risk 
MISSION STATEMENT 
PROCESS 
TRANSACTION APROVAL 
DEAL EXECUTION AND BOOKING 
MODELS 
(Initial development, implementation in the systems and Model control framework) 
RESERVES AND VALUATION ADJUSTMENTS POLICY 
MARKET PARAMETERS VALIDATION 
P&L PRODUCTION 
Compulsory member with escalation right in dedicated committees (NPC, TAC) 
Responsible for 1st level controls on 
complex deals booking 
Responsible for the model control framework (approval, review and mapping) 
Responsible for uncertainty or liquidity 
reserves valuation 
Responsible for controls defined in the flowcharts of official market parameters Responsible for controls on “non standard” parameters 
Validate the observability status of 
parameters (for the Day One P&L 
adjustments) 
Modelconception&implementation 
formallyapproveanynewvaluationmodelormodificationofvaluationmethodologyfollowingaspecificprocedure(superviseback-testingandnumericaltestsperformedbyResearch/ITteams) 
assessthevalidityofthemodel’stheoreticalrepresentationandtheadequacyofthemodeltotheproducttowhichitapplies 
reviewtheresultsoftestsonreliabilityandqualityoftheITcode,andhasauthoritytoaskthatfurthertestingiscarriedoutand 
finallyauthorisestheuseofthismodelforofficialvaluation(go-live) 
2.Modeloperationaluse 
isresponsibleforthesettingandthemaintenanceofthelistofofficial(authorised)models,thatincludesthenumerical 
configurations,thecalibrationprocedureand/orset,andtheofficialusagerules(scopeofproductstowhichamodelapplies 
throughtheproduct/modelmapping) 
isinchargeofverifyingthatthevaluationmodelusedforoff-systemsdealsisadequate(inaccordancetotheproduct/model 
mapping) 
Performspecificcontrolsondealswithnotyetmodelsorspecificcharacteristics(reserves,limits…) 
Zoom # 1 
Zoom # 2 
Market Supervision and validation: a complex control frameworkZoom on the risk function
6 
Pricing & Validation key issues 
Approach 
Appendixes 
CH&Cie presentation: risk management offer 
Agenda 
1 
2 
3 
4
7 
Market Model review 
Review of MtModel 
consistency & robustness 
Review of Model and 
pricing system 
Mapping & 
output analysis 
Analytical review 
of model results 
Gap analysis of 
key parameters 
Dif ferences 
explanation 
Data 
quality 
Inputs / 
components 
Model design 
Design 
benchmark 
Calculation 
process 
Closed Formula 
Monte Carlo 
simulations 
Trees / other … 
Scenarios 
review 
Simulations 
convergence 
Market Risk 
parameters 
Other Risk 
Market direct 
access 
No access => 
MtModel 
Partial access / 
Smoothng / 
interpolation 
Lquidity 
Maret 
volatlity / 
stress 
CVA/DVA 
Cross 
gamma 
effect 
Step 2: 
Review global 
methodology 
Step 1: 
Preliminary 
diagnosis 
Step 3: detailed review of a core 
component 
Arbitrage 
… 
Correlation 
Step 2: 
Review global 
Methodology 
Step 1: 
Preliminary 
Diagnostic 
Step 3: 
Detailed review of the core 
components 
This approach is also designed to address regulatory expectations 
Pricing & validation: a vertical integration in business 
CH&Cie review approach
8 
Reviewing a model should encompass: 
Qualitativeprocess: 
Qualitativereviewandmanagementoversight 
Modeloperatingenvironment 
Systemsimplementation 
Dataqualitychecks 
Examinationofassumptions 
Quantitativeprocess: 
Reviewofinputandparameters 
Modelreplication 
Benchmarkingandhypotheticalportfoliotesting 
Backtestingandstresstesting 
•Profitandlossattribution 
The model operating environment includes: 
Modeldocumentationanditsreview 
Reviewoftheoreticalsoundness 
Reviewofmodelimplementation(includingsystemsanddataquality) 
Reviewofmodelinputs 
Reviewofmodelassumptions,limitationsandusage 
Implementationandreviewofmodelcontrols 
Environment analysis: 
Vacuum of the snapshot 
Heterogenity& asynchronicity 
To validate a model is not strictly limited to a quantitative review. The environment and the internal organisation’s «fit» is also tested 
Model review functions in motionFrom a quantitative tool to a more business oriented instrument with strategic guidance
9 
Is the model answering all the bank expectations? 
What is the trading strategy? 
What are the criteria for validating a model? 
Risk of mispricing? (new model, strong assumptions, strong hypothesis …) 
Very sensitive model? (Greeks and parameter sensitivities are high …) 
Risk of P&L swings? Easy to Hedge or not? Very expensive to hedge? 
Complex to follow or not? (change in portfolio composition / change in the underlying maturities …) 
Risk of arbitrage? 
No benchmark? Mark to Model? (no market price, partial quotes …) 
Illiquid market? (higher bid-ask spreads…) 
Instability of the model under stress conditions? 
Regulatory risk? (Arbitrage in ISDA or CSA contracts …) 
Capital requirement is too high? (Basel III, cash collateral requirements …) 
Avoid gamma holes 
When volatility is high, gamma is high, hedging is expensive 
Large gamma may show imperfect hedge and possible jumps in PnL(barrier options) 
When gamma changes sign (spread options), delta hedge is not possible 
Monetize variance risk premia 
Sell implied, buy realized volatility by creating a flat dollar gamma portfolio, go long gamma 
Volatility term structure arbitrage 
After the crisis we expect short volatility to decrease and long volatility to increase 
Sell short volatility, buy long volatility by delta hedged straddles 
Smile arbitrage 
Volatilities are extremely volatile, but volatility smile is always flat 
Sell straddle, buy butterfly 
Monetize liquidity risk premium 
Borrow on short-term, lend on long-term 
… 
Model review functions in motion 
Critical choices and model functions needs to be tested
10 
Pricing & Validation key issues 
Approach 
Appendixes 
CH&Cie presentation: risk management offer 
Agenda 
1 
2 
3 
4
11 
A Range Accrual is a structured product which pays a coupon based on the performance of the underlying (Equity Index, FX or interest rates…) 
The Performance coupon pays an amount based on the number of days the underlying performance is within a defined Range 
Sometimes, a short option (generally a Put Down & In) is added in the package; in this case, the capital is not guaranteed, but the Accrual In Rate is greater 
Sometimes, the product is callable: if at any fixing date, the underlying performance is above the Range Cap, then the product is called (totally redeemed @ Capital + last coupon) 
Description 
Days within Accrual Range 
Days out of Accrual Range 
Days out of Accrual Range 
Illustration with a Range Accrual on Libor 3M 
The coupon can be modeled as the sum of 
•The Accrual In Rate for all the period 
•A series of daily short binary strangles (with Strike 1 = Floor, Strike 2 = Cap, Notional = Accrual In Rate / Total Number of days) 
Modeling 
At each fixing date, the performance rate is: 
Accrual In Rate & Accrual Out Rate are defined at inception, generally Accrual Out Rate equals 0. 
Accrual In Rate depends of Range Floor & Cap levels 
Payoff 
Number of days within Accrual Range 
Total Number of days 
Number of days out of Accrual Range 
Total Number of days 
X 
Accrual Out Rate 
X 
Accrual In Rate 
+ 
Range Accrual Description
12 
There are 5 periods of one year 
At each observation dates (everyday), the performance used is the worst performance between S&P500, NKY & EUROSTOXX50 performances 
The Accrual Range is 80%-100%, The Accrual In Rate is 7%, The Accrual Out rate is 0 
The Put Down & In can be activated only at maturity (Final PDI), its activation barrier is at 80%, and its strike at 100% 
Description 
The coupon of one isolated period can be modeled as the sum of 
•The Accrual In Rate for all the period 
•A series of daily short binary strangles (with Strike 1 = Floor, Strike 2 = Cap, Notional = Accrual In Rate / Total Number of days) 
The Call-ability adds a conditional factor on each future coupon, on the PDI, and on the Capital Funding 
The PDI adds a jump of (strike -barrier) at its barrier 
Modeling 
At each fixing date (each year): 
•Performance rate (chart below): The performance was within the Range n days on a period of N days, the coupon is: Accrual In Rate * n / N 
•Call-ability: If the performance is above the range, then the product is called (totally redeemed @ Capital + Coupon of current period) 
Payoff 
At maturity, if the product has not been called, 
Last Coupon: Performance coupon as for other periods 
Final PDI 80%/100% (chart below): If the Performance is under 80%, the Put Down & In is activated, then the product redeems the capital multiplied by the underlying performance (if the performance is -40%, the note redeems 60% of the initial capital) 
An example: a 5 years 7% Callable Range Accrual 80%-100% with 1 Final PDI 80%/100% on the worst performer of (S&P500, NKY, EUROSTOXX50)
13 
Pricing & Validation key issues 
Approach 
Appendixes 
CH&Cie: Focus on the Risk Management offer 
Agenda 
1 
2 
3 
4
14 
CH&Cie Risk Management offer (1/4) From managing risk processes, to measuring risks and establishing strategic guidance 
Strategic 
guidance 
Measurement & 
validation 
Processes & organisation 
Risk Management 
1 
2 
3 
•Helpingtomakinghigh-leveldecision(CVAdeskimplementationetc…) 
•Definingriskappetiteinaccordancewiththebusinessstrategy&development 
Strategic guidance 
Measurement & Validation 
•Quantifying risks and measuring impacts on a business level 
•Validating models and developing advanced quantitative techniques 
Processes & organization 
•Reviewing risk management processes 
•Establishing monitoring procedures 
•Organizing and defining risk governance and follow-up
15 
1. Finance 
2. Pricing 
3. ALM / Liquidity 
4. Credit Risk 
5. Market Risk 
6. Operat. Risk 
7. Business & Strategy 
8. Customer relationship management 
1.1ICAAP / Pillar 2 
1.2Economic capital 
1.3Capital budgeting / RAPM 
1.4P&L and budget forecasting 
2.1Standard & Complex Models 
2.2Instrument pricing 
2.3Pricing Parameters control 
3.1Basel III : LCR, NSFR, liquidity 
3.2Securitization SPV, collat. manag. 
3.3Gap : CF patterns, survival horiz 
3.4Dynamic modeling 
4.1Basel II: PD, LGD, EAD, CCF, UL, RWA 
4.2Basel III, CVA, CCP, Capital 
4.3Solvency II : capital 
4.4Provision specific, collective 
4.5Stress & back testing 
5.1Classic & stress VaR, CVar 
5.2Risk reserves 
5.3Sensitivities Modeling & Calculation 
5.4Incrementaland liquidityrisk 
6.1Fraud detection 
6.2AMA models 
6.3Rogue trading 
7.1Strategy guidance and decision 
7.2Brand notoriety, reputation 
7.3Process optimization 
8.1Credit granting models 
8.2Portfolio scoring 
8.3Marketing and targeting 
8.4Data mining and desctriptive statistics 
CH&Cie Risk Management offer (2/4) A large scope of intervention with expertise, experience and benchmarking at the heart of our strategy 
0. Advanced Modeling, experience, expertise, benchmarking 
Please, specify the subjects you are interested in, by checking the orange boxes 
Legend 
Business intent 
Regulatory intent 
6.4Operations structuringcontrol
16 
CH&Cie Risk Management offer(3/4) Modeling as an integrated business tool: a cross-disciplinary skills and decision-making facilitator tool 
Modelingas a 
transversal tool 
Risks 
1 
•Market:VaRcomputing,volatility, liquidity,valuation 
•Credit:BaselIIparameters, Provisioning,stress,backtesting 
•Operational:fraud,roguetrading... 
Finance 
2 
•ManageAssetsandLiabilities 
•ManageEconomiccapital(ICAAP) 
•SimulateP&Limpacts 
•CapitalBudgeting:RAROCetc… 
Business 
3 
•Optimizeoperatingmodel 
•Adaptmarketing(CRM) 
•Scoringandtargetingcustomers 
Strategy 
4 
•Buildbusinessstrategy 
•Monitorreputation 
•Arbitragebetweenrisktakingandbusinessdevelopement 
Modeling allows to anticipate, prevent, detect, measure, test, develop and decide… It is a powerful tool that requires a specific set of skills and knowledge
17 
CH&Cie Risk Management offer(4/4) 
Modeling techniques and requirements: the work tools 
1 Data analysis 
• To give a quantitative 
perspective of a 
specific context or for 
problem detections 
(by analysing data) 
Main objectives 
2 Simulation 3 Solving 4 Prediction 5 Methods 
• To validate hypotesis 
and / or find the best 
option of a specific 
strategy 
• To give a closed 
formula of a specific 
problem 
• To give an estimate or 
a prediction (estimed 
probability of an event 
to happen under 
certain hypothesis) 
• To define and design a 
quantitative 
methodoloy for 
strategy purposes or 
business decision 
• Data Mining 
• Statistics 
Underlying 
techniques 
• Monte Carlo 
simulation 
• Bayesian networks 
• Fuzzy logic / Expertise 
• Mathematics 
• Statistics 
• Probability 
• Statistics 
• Benchmark 
• Experience/ Best 
practices 
• Fraud detection 
• Portfolio analysis 
• Correlation analysis 
• Dashboard / reporting 
• Marketing … 
Illustrations • Capital planning 
• Strategic plan 
forecasting 
• Pricing 
• Stress testing … 
• RWA Calculation 
• Pricing 
• Marketing 
• Valuation (firm 
value)… 
• Risk parameter 
estimation (PD, LGD, 
EAD) 
• VaR / Credit VaR … 
• CVA desk implement. 
• « Cost of risk » 
hedging policy 
• Choice among 
different approaches 
… 
AAA 
AA 
A+ 
A-BBB 
BB+ 
BB-B 
CCC 
DX 
- 
200 
400 
600 
800 
1 000 
1 200 
2011 
2012 
2013 
2014 
2015 
2 020 
2 030 
2 040 
2 050 
2 060 
2 070 
2 080 
2 090 
2 100 
Rating 
Number of clients 
Maturity 
Profile analysis 
  
 
 
 
 
 
 
 
 
 
  
  
  
 
i 
i i 
i 
p y 
P Z Y y 
 
 
1 
( ) 
1 
1 
Markov 
Models 
Regression models 
Vintage analysis 
Binomial Tree 
Actuarial models (Beta calibration) 
Statistical 
Models 
Loss Calc 
Others... 
External 
Models 
Recovery 
Assessment models
MONTREAL 
202 –1819 Bd ReneLevesque O. 
Montreal, Quebec, H3H2P5 
PARIS 
20, rue de la Michodière75002 Paris, France 
NIORT 
19 avenue Bujault 
79000 Niort, France 
NEW YORK 
1441, BroadwaySuite 3015, New YorkNY 10018, USA 
SINGAPORE 
Level25, NorthTower, 
One Raffles Quay, Singapore 048583 
HONG KONG 
905, 9/F, 
KinwickCentre 32 Hollywood Road, 
Central, Hong Kong 
LONDON 
50 Great Portland Street 
London W1W 7ND 
UK 
GENEVA 
Rue de Lausanne 80CH 1202 Genève, Suisse

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Pricing model validation and process review document analysis

  • 1. Pricing model validation and process review 22th, September2014 Stephane Eyraud seyraud@chappuishalder.com Benoit Genest bgenest@chappuishalder.com
  • 2. 2 Pricing & Validation key issues Approach Appendixes CH&Cie presentation: risk management offer Agenda 1 2 3 4
  • 3. 3 Finance delegates to CIB Finance the supervision of the entire P&L and valuation control process CIB Finance responsibility is carried out through “CIB Financial Control” and the coordination of the governance structure CIB Financial control is a “global” finance control function which is responsible for supervision of the entire Valuation and P&L Control framework (which includes 1st and 2nd level controls) across capital market activities, global coordination (prepares and drives the monthly Committees that examine all issues relating to valuation, P&L and system booking) The responsibility is shared by many players, each of them is responsible for their respective perimeter Operations Front Office Risk Finance Middle Office & Product control Back Office Global Finance Headquarter Global Finance Control CIB Local Finance Global Finance Control Local 1 2 3 4 Based on the charter of responsibilities, which defines the breakdown of responsibilities on the valuation and P&L controls, the organization is placed under the supervision of the Finance function Finance guarantees the production and the quality of the Group financial statements and Group Management accounts Finance uses to delegate the production and control of the financial instruments’ fair value, to the various participants Finance delegates to Risk the authority to control the fair value of the financial instruments booked in the Group accounts (models, parameters) Market Supervision and validation: a complex control frameworkGeneral Overview: Functional organization & delegation principles
  • 4. 4 Ensurecorrectrepresentationofoperationsintheofficialsystems Determinethemarketparameterstobeusedandensuretheirdailycontribution Contributetotheobservabilityassessmentwork Proposemodificationstothemodelsandvaluationmethodologies Supervisemodelimplementationwork ContributetotheeconomicP&Lvalidation AreresponsiblefortheimplementationoftheFOsystemsthataresecureandthatfulfilthecontrolobjectives. Front Office Finance Operations Risk Define the adequate economic valuation methodologies and establish a reserve policy covering model, parameter and liquidity risks Approve and review the models used by the Front Office Draw up and maintain the “models/products” mapping Contribute to the controls over deal representation in the systems, when no booking rules have been set Have authority over the observability status of market parameters and products Are directly responsible for the control of the non- standard market parameters, and are responsible for assisting Operations in the implementation of the standard parameter controls Determine reserves. Ensurethatthedealrepresentationintheofficialsystemsarecompliantwithasetofpre-definedrules EnsurethattransactiondetailsbookedbytheFOthatimpacttheeconomicrevaluationareproperlyreconciledwiththecontractualterms Validatethe“standard”marketparameters Contributetothereservescalculationprocess(undertheresponsibilityofRCM) Produce,analyseandvalidate(substantiate)theofficialP&L ContributetothereconciliationbetweentheaccountingP&LandtheeconomicP&L ContributetocalculationoftheDayOneP&Ladjustments Ensuretheaccurateprocessingofoperations(i.e.clearingandsettlement,paymentandcashmanagement,confirmations) Performoperationalcontrols(i.e.resolutionofunsettleddeals,reconciliationofcashandsecuritiesmovementswithclearer/custodian/broker) Middle Office & Product Control Back Office EnsurethesupervisionoftheentireValuationandP&LControlframework(firstandsecondlevelcontrols)throughtheconsolidationandanalysisofthereportsreceivedfromallthecontributorstotheValuationandP&LControlChain Prepareandcoordinatethemonthlyandquarterlymeetings. Coordinatethegovernancestructure,namelymonthlyP&Landquarterlyexecutive Headquarter Local PerformthefirstlevelcontrolsthatarewithintheFinancearea,notablyaccountingcontrols; PerformthereconciliationbetweenaccountingandeconomicP&Ls, Assumetheentity-specificpartofthe“CIBFinancialControl”supervisionmandate 1 2 3 4 Market Supervision and validation: a complex control frameworkFocus on mission statements (Key responsibilities)
  • 5. 5 Front Office BackOffice Finance Risk MISSION STATEMENT PROCESS TRANSACTION APROVAL DEAL EXECUTION AND BOOKING MODELS (Initial development, implementation in the systems and Model control framework) RESERVES AND VALUATION ADJUSTMENTS POLICY MARKET PARAMETERS VALIDATION P&L PRODUCTION Compulsory member with escalation right in dedicated committees (NPC, TAC) Responsible for 1st level controls on complex deals booking Responsible for the model control framework (approval, review and mapping) Responsible for uncertainty or liquidity reserves valuation Responsible for controls defined in the flowcharts of official market parameters Responsible for controls on “non standard” parameters Validate the observability status of parameters (for the Day One P&L adjustments) Modelconception&implementation formallyapproveanynewvaluationmodelormodificationofvaluationmethodologyfollowingaspecificprocedure(superviseback-testingandnumericaltestsperformedbyResearch/ITteams) assessthevalidityofthemodel’stheoreticalrepresentationandtheadequacyofthemodeltotheproducttowhichitapplies reviewtheresultsoftestsonreliabilityandqualityoftheITcode,andhasauthoritytoaskthatfurthertestingiscarriedoutand finallyauthorisestheuseofthismodelforofficialvaluation(go-live) 2.Modeloperationaluse isresponsibleforthesettingandthemaintenanceofthelistofofficial(authorised)models,thatincludesthenumerical configurations,thecalibrationprocedureand/orset,andtheofficialusagerules(scopeofproductstowhichamodelapplies throughtheproduct/modelmapping) isinchargeofverifyingthatthevaluationmodelusedforoff-systemsdealsisadequate(inaccordancetotheproduct/model mapping) Performspecificcontrolsondealswithnotyetmodelsorspecificcharacteristics(reserves,limits…) Zoom # 1 Zoom # 2 Market Supervision and validation: a complex control frameworkZoom on the risk function
  • 6. 6 Pricing & Validation key issues Approach Appendixes CH&Cie presentation: risk management offer Agenda 1 2 3 4
  • 7. 7 Market Model review Review of MtModel consistency & robustness Review of Model and pricing system Mapping & output analysis Analytical review of model results Gap analysis of key parameters Dif ferences explanation Data quality Inputs / components Model design Design benchmark Calculation process Closed Formula Monte Carlo simulations Trees / other … Scenarios review Simulations convergence Market Risk parameters Other Risk Market direct access No access => MtModel Partial access / Smoothng / interpolation Lquidity Maret volatlity / stress CVA/DVA Cross gamma effect Step 2: Review global methodology Step 1: Preliminary diagnosis Step 3: detailed review of a core component Arbitrage … Correlation Step 2: Review global Methodology Step 1: Preliminary Diagnostic Step 3: Detailed review of the core components This approach is also designed to address regulatory expectations Pricing & validation: a vertical integration in business CH&Cie review approach
  • 8. 8 Reviewing a model should encompass: Qualitativeprocess: Qualitativereviewandmanagementoversight Modeloperatingenvironment Systemsimplementation Dataqualitychecks Examinationofassumptions Quantitativeprocess: Reviewofinputandparameters Modelreplication Benchmarkingandhypotheticalportfoliotesting Backtestingandstresstesting •Profitandlossattribution The model operating environment includes: Modeldocumentationanditsreview Reviewoftheoreticalsoundness Reviewofmodelimplementation(includingsystemsanddataquality) Reviewofmodelinputs Reviewofmodelassumptions,limitationsandusage Implementationandreviewofmodelcontrols Environment analysis: Vacuum of the snapshot Heterogenity& asynchronicity To validate a model is not strictly limited to a quantitative review. The environment and the internal organisation’s «fit» is also tested Model review functions in motionFrom a quantitative tool to a more business oriented instrument with strategic guidance
  • 9. 9 Is the model answering all the bank expectations? What is the trading strategy? What are the criteria for validating a model? Risk of mispricing? (new model, strong assumptions, strong hypothesis …) Very sensitive model? (Greeks and parameter sensitivities are high …) Risk of P&L swings? Easy to Hedge or not? Very expensive to hedge? Complex to follow or not? (change in portfolio composition / change in the underlying maturities …) Risk of arbitrage? No benchmark? Mark to Model? (no market price, partial quotes …) Illiquid market? (higher bid-ask spreads…) Instability of the model under stress conditions? Regulatory risk? (Arbitrage in ISDA or CSA contracts …) Capital requirement is too high? (Basel III, cash collateral requirements …) Avoid gamma holes When volatility is high, gamma is high, hedging is expensive Large gamma may show imperfect hedge and possible jumps in PnL(barrier options) When gamma changes sign (spread options), delta hedge is not possible Monetize variance risk premia Sell implied, buy realized volatility by creating a flat dollar gamma portfolio, go long gamma Volatility term structure arbitrage After the crisis we expect short volatility to decrease and long volatility to increase Sell short volatility, buy long volatility by delta hedged straddles Smile arbitrage Volatilities are extremely volatile, but volatility smile is always flat Sell straddle, buy butterfly Monetize liquidity risk premium Borrow on short-term, lend on long-term … Model review functions in motion Critical choices and model functions needs to be tested
  • 10. 10 Pricing & Validation key issues Approach Appendixes CH&Cie presentation: risk management offer Agenda 1 2 3 4
  • 11. 11 A Range Accrual is a structured product which pays a coupon based on the performance of the underlying (Equity Index, FX or interest rates…) The Performance coupon pays an amount based on the number of days the underlying performance is within a defined Range Sometimes, a short option (generally a Put Down & In) is added in the package; in this case, the capital is not guaranteed, but the Accrual In Rate is greater Sometimes, the product is callable: if at any fixing date, the underlying performance is above the Range Cap, then the product is called (totally redeemed @ Capital + last coupon) Description Days within Accrual Range Days out of Accrual Range Days out of Accrual Range Illustration with a Range Accrual on Libor 3M The coupon can be modeled as the sum of •The Accrual In Rate for all the period •A series of daily short binary strangles (with Strike 1 = Floor, Strike 2 = Cap, Notional = Accrual In Rate / Total Number of days) Modeling At each fixing date, the performance rate is: Accrual In Rate & Accrual Out Rate are defined at inception, generally Accrual Out Rate equals 0. Accrual In Rate depends of Range Floor & Cap levels Payoff Number of days within Accrual Range Total Number of days Number of days out of Accrual Range Total Number of days X Accrual Out Rate X Accrual In Rate + Range Accrual Description
  • 12. 12 There are 5 periods of one year At each observation dates (everyday), the performance used is the worst performance between S&P500, NKY & EUROSTOXX50 performances The Accrual Range is 80%-100%, The Accrual In Rate is 7%, The Accrual Out rate is 0 The Put Down & In can be activated only at maturity (Final PDI), its activation barrier is at 80%, and its strike at 100% Description The coupon of one isolated period can be modeled as the sum of •The Accrual In Rate for all the period •A series of daily short binary strangles (with Strike 1 = Floor, Strike 2 = Cap, Notional = Accrual In Rate / Total Number of days) The Call-ability adds a conditional factor on each future coupon, on the PDI, and on the Capital Funding The PDI adds a jump of (strike -barrier) at its barrier Modeling At each fixing date (each year): •Performance rate (chart below): The performance was within the Range n days on a period of N days, the coupon is: Accrual In Rate * n / N •Call-ability: If the performance is above the range, then the product is called (totally redeemed @ Capital + Coupon of current period) Payoff At maturity, if the product has not been called, Last Coupon: Performance coupon as for other periods Final PDI 80%/100% (chart below): If the Performance is under 80%, the Put Down & In is activated, then the product redeems the capital multiplied by the underlying performance (if the performance is -40%, the note redeems 60% of the initial capital) An example: a 5 years 7% Callable Range Accrual 80%-100% with 1 Final PDI 80%/100% on the worst performer of (S&P500, NKY, EUROSTOXX50)
  • 13. 13 Pricing & Validation key issues Approach Appendixes CH&Cie: Focus on the Risk Management offer Agenda 1 2 3 4
  • 14. 14 CH&Cie Risk Management offer (1/4) From managing risk processes, to measuring risks and establishing strategic guidance Strategic guidance Measurement & validation Processes & organisation Risk Management 1 2 3 •Helpingtomakinghigh-leveldecision(CVAdeskimplementationetc…) •Definingriskappetiteinaccordancewiththebusinessstrategy&development Strategic guidance Measurement & Validation •Quantifying risks and measuring impacts on a business level •Validating models and developing advanced quantitative techniques Processes & organization •Reviewing risk management processes •Establishing monitoring procedures •Organizing and defining risk governance and follow-up
  • 15. 15 1. Finance 2. Pricing 3. ALM / Liquidity 4. Credit Risk 5. Market Risk 6. Operat. Risk 7. Business & Strategy 8. Customer relationship management 1.1ICAAP / Pillar 2 1.2Economic capital 1.3Capital budgeting / RAPM 1.4P&L and budget forecasting 2.1Standard & Complex Models 2.2Instrument pricing 2.3Pricing Parameters control 3.1Basel III : LCR, NSFR, liquidity 3.2Securitization SPV, collat. manag. 3.3Gap : CF patterns, survival horiz 3.4Dynamic modeling 4.1Basel II: PD, LGD, EAD, CCF, UL, RWA 4.2Basel III, CVA, CCP, Capital 4.3Solvency II : capital 4.4Provision specific, collective 4.5Stress & back testing 5.1Classic & stress VaR, CVar 5.2Risk reserves 5.3Sensitivities Modeling & Calculation 5.4Incrementaland liquidityrisk 6.1Fraud detection 6.2AMA models 6.3Rogue trading 7.1Strategy guidance and decision 7.2Brand notoriety, reputation 7.3Process optimization 8.1Credit granting models 8.2Portfolio scoring 8.3Marketing and targeting 8.4Data mining and desctriptive statistics CH&Cie Risk Management offer (2/4) A large scope of intervention with expertise, experience and benchmarking at the heart of our strategy 0. Advanced Modeling, experience, expertise, benchmarking Please, specify the subjects you are interested in, by checking the orange boxes Legend Business intent Regulatory intent 6.4Operations structuringcontrol
  • 16. 16 CH&Cie Risk Management offer(3/4) Modeling as an integrated business tool: a cross-disciplinary skills and decision-making facilitator tool Modelingas a transversal tool Risks 1 •Market:VaRcomputing,volatility, liquidity,valuation •Credit:BaselIIparameters, Provisioning,stress,backtesting •Operational:fraud,roguetrading... Finance 2 •ManageAssetsandLiabilities •ManageEconomiccapital(ICAAP) •SimulateP&Limpacts •CapitalBudgeting:RAROCetc… Business 3 •Optimizeoperatingmodel •Adaptmarketing(CRM) •Scoringandtargetingcustomers Strategy 4 •Buildbusinessstrategy •Monitorreputation •Arbitragebetweenrisktakingandbusinessdevelopement Modeling allows to anticipate, prevent, detect, measure, test, develop and decide… It is a powerful tool that requires a specific set of skills and knowledge
  • 17. 17 CH&Cie Risk Management offer(4/4) Modeling techniques and requirements: the work tools 1 Data analysis • To give a quantitative perspective of a specific context or for problem detections (by analysing data) Main objectives 2 Simulation 3 Solving 4 Prediction 5 Methods • To validate hypotesis and / or find the best option of a specific strategy • To give a closed formula of a specific problem • To give an estimate or a prediction (estimed probability of an event to happen under certain hypothesis) • To define and design a quantitative methodoloy for strategy purposes or business decision • Data Mining • Statistics Underlying techniques • Monte Carlo simulation • Bayesian networks • Fuzzy logic / Expertise • Mathematics • Statistics • Probability • Statistics • Benchmark • Experience/ Best practices • Fraud detection • Portfolio analysis • Correlation analysis • Dashboard / reporting • Marketing … Illustrations • Capital planning • Strategic plan forecasting • Pricing • Stress testing … • RWA Calculation • Pricing • Marketing • Valuation (firm value)… • Risk parameter estimation (PD, LGD, EAD) • VaR / Credit VaR … • CVA desk implement. • « Cost of risk » hedging policy • Choice among different approaches … AAA AA A+ A-BBB BB+ BB-B CCC DX - 200 400 600 800 1 000 1 200 2011 2012 2013 2014 2015 2 020 2 030 2 040 2 050 2 060 2 070 2 080 2 090 2 100 Rating Number of clients Maturity Profile analysis                   i i i i p y P Z Y y   1 ( ) 1 1 Markov Models Regression models Vintage analysis Binomial Tree Actuarial models (Beta calibration) Statistical Models Loss Calc Others... External Models Recovery Assessment models
  • 18. MONTREAL 202 –1819 Bd ReneLevesque O. Montreal, Quebec, H3H2P5 PARIS 20, rue de la Michodière75002 Paris, France NIORT 19 avenue Bujault 79000 Niort, France NEW YORK 1441, BroadwaySuite 3015, New YorkNY 10018, USA SINGAPORE Level25, NorthTower, One Raffles Quay, Singapore 048583 HONG KONG 905, 9/F, KinwickCentre 32 Hollywood Road, Central, Hong Kong LONDON 50 Great Portland Street London W1W 7ND UK GENEVA Rue de Lausanne 80CH 1202 Genève, Suisse