This document discusses the roles and responsibilities of various parties in the pricing and validation process at a bank. Finance has overall responsibility for financial reporting and delegates pricing and valuation control to other functions. Risk is responsible for approving models and setting market parameters. Front office is responsible for deal execution while middle office validates standard parameters and produces P&L statements. Operations ensures accurate deal representation in systems.

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
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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
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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
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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
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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
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400
600
800
1 000
1 200
2011
2012
2013
2014
2015
2 020
2 030
2 040
2 050
2 060
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2 100
Rating
Number of clients
Maturity
Profile analysis
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Markov
Models
Regression models
Vintage analysis
Binomial Tree
Actuarial models (Beta calibration)
Statistical
Models
Loss Calc
Others...
External
Models
Recovery
Assessment models

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