Physical-Measure Future Value Distributions

Wed, 07/08/2013 - 5:30pm

Andy McClelland, Numerix LLC


Westpac Conference Centre, Plaza Level, 60 Martin Place, Sydney

Presented by: Andy McClelland, Numerix LLC

Time: 5:30pm
Date: Wednesday 7 August 2013
Venue: Westpac Conference Centre, Plaza Level, 60 Martin Place, Sydney


This talk explores the production of future value distributions for derivatives under the physical, as opposed to risk-neutral, probability measure. These quantities are relevant to banks assessing their potential exposures to counterparties, or to life companies pricing the policies offered to their clients, among other things. First, the role of risk premia in determining the difference between the physical evolution and risk-neutral evolution of a derivative’s value is reviewed. It is demonstrated that the risk-neutral distribution can be more or less conservative than its physical counterpart depending upon both the sensitivity of the instrument to underlying market factors and the risk premia associated with those factors. The method of producing risk-neutral future value distributions for structured deals via Longstaff Schwartz (2001) regression is then discussed, and this method is compared with the Monte Carlo-on-Monte Carlo method. Finally, a change-of-measure process is embedded within the regression procedure to allow for its use towards producing physical future value distributions. Some comments regarding the estimation of risk premia-governing parameters are also offered.

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