A Conversation with Chris Heyde

Born in Sydney, Australia, on April 20, 1939, Chris Heyde shifted his interest from sport to mathematics thanks to inspiration from a schoolteacher. After earning an M.Sc. degree from the University of Sydney and a Ph.D. from the Australian National University (ANU), he began his academic career in the United States at Michigan State University, and then in the United Kingdom at the University of Sheffield and the University of Manchester. In 1968, Chris moved back to Australia to teach at ANU until 1975, when he joined CSIRO, where he was Acting Chief of the Division of Mathematics and Statistics. From 1983 to 1986, he was a Professor and Chairman of the Department of Statistics at the University of Melbourne. Chris then returned to ANU to become the Head of the Statistics Department, and later the Foundation Dean of the School of Mathematical Sciences (now the Mathematical Sciences Institute). Since 1993, he has also spent one semester each year teaching at the Department of Statistics, Columbia University, and has been the director of the Center for Applied Probability at Columbia University since its creation in 1993. Chris has been honored worldwide for his contributions in probability, statistics and the history of statistics. He is a Fellow of the International Statistical Institute and the Institute of Mathematical Statistics, and he is one of three people to be a member of both the Australian Academy of Science and the Australian Academy of Social Sciences. In 2003, he received the Order of Australia from the Australian government. He has been awarded the Pitman Medal and the Hannan Medal. Chris was conferred a D.Sc. honoris causa by University of Sydney in 1998. Chris has been very active in serving the statistical community, including as the Vice President of the International Statistical Institute, President of the Bernoulli Society and Vice President of the Australian Mathematical Society. He has served on numerous editorial boards, most notably as Editor of Stochastic Processes and Their Applications from 1983 to 1989, and as Editor-in-Chief of Journal of Applied Probability and Advances in Applied Probability since 1990.Comment: Published at http://dx.doi.org/10.1214/088342306000000088 in the Statistical Science (http://www.imstat.org/sts/) by the Institute of Mathematical Statistics (http://www.imstat.org

Number of paths versus number of basis functions in American option pricing

An American option grants the holder the right to select the time at which to exercise the option, so pricing an American option entails solving an optimal stopping problem. Difficulties in applying standard numerical methods to complex pricing problems have motivated the development of techniques that combine Monte Carlo simulation with dynamic programming. One class of methods approximates the option value at each time using a linear combination of basis functions, and combines Monte Carlo with backward induction to estimate optimal coefficients in each approximation. We analyze the convergence of such a method as both the number of basis functions and the number of simulated paths increase. We get explicit results when the basis functions are polynomials and the underlying process is either Brownian motion or geometric Brownian motion. We show that the number of paths required for worst-case convergence grows exponentially in the degree of the approximating polynomials in the case of Brownian motion and faster in the case of geometric Brownian motion.Comment: Published at http://dx.doi.org/10.1214/105051604000000846 in the Annals of Applied Probability (http://www.imstat.org/aap/) by the Institute of Mathematical Statistics (http://www.imstat.org

Linear Classifiers Under Infinite Imbalance

We study the behavior of linear discriminant functions for binary classification in the infinite-imbalance limit, where the sample size of one class grows without bound while the sample size of the other remains fixed. The coefficients of the classifier minimize an expected loss specified through a weight function. We show that for a broad class of weight functions, the intercept diverges but the rest of the coefficient vector has a finite limit under infinite imbalance, extending prior work on logistic regression. The limit depends on the left tail of the weight function, for which we distinguish three cases: bounded, asymptotically polynomial, and asymptotically exponential. The limiting coefficient vectors reflect robustness or conservatism properties in the sense that they optimize against certain worst-case alternatives. In the bounded and polynomial cases, the limit is equivalent to an implicit choice of upsampling distribution for the minority class. We apply these ideas in a credit risk setting, with particular emphasis on performance in the high-sensitivity and high-specificity regions

Valuing the Treasury's Capital Assistance Program

The Capital Assistance Program (CAP) was created by the U.S. government in February 2009 to provide backup capital to large financial institutions unable to raise sufficient capital from private investors. Under the terms of the CAP, a participating bank receives contingent capital by issuing preferred shares to the Treasury combined with embedded options for both parties: the bank gets the option to redeem the shares or convert them to common equity, with conversion mandatory after seven years; the Treasury earns dividends on the preferred shares and gets warrants on the bank's common equity. We develop a contingent claims framework in which to estimate market values of these CAP securities. The interaction between the competing options held by the buyer and issuer of these securities creates a game between the two parties, and our approach captures this strategic element of the joint valuation problem and clarifies the incentives it creates. We apply our method to the eighteen publicly held bank holding companies that participated in the Supervisory Capital Assessment Program (the stress test) launched together with the CAP. On average, we estimate that, compared to a market transaction, the CAP securities carry a net value of approximately 30 percent of the capital invested for a bank participating to the maximum extent allowed under the terms of the program. We also find that the net value varies widely across banks. We compare our estimates with abnormal stock price returns for the stress test banks at the time the terms of the CAP announced; we find correlations between 0.78 and 0.85, depending on the precise choice of period and set of banks included. These results suggest that our valuation aligns with shareholders' perception of the value of the program, prompting questions about industry reactions and the overall impact of the program

Contagion in financial networks

The recent financial crisis has prompted much new research on the interconnectedness of the modern financial system and the extent to which it contributes to systemic fragility. Network connections diversify firms' risk exposures, but they also create channels through which shocks can spread by contagion. We review the extensive literature on this issue, with the focus on how network structure interacts with other key variables such as leverage, size, common exposures, and short-term funding. We discuss various metrics that have been proposed for evaluating the susceptibility of the system to contagion and suggest directions for future research

New News is Bad News

An increase in the novelty of news predicts negative stock market returns and negative macroeconomic outcomes over the next year. We quantify news novelty - changes in the distribution of news text - through an entropy measure, calculated using a recurrent neural network applied to a large news corpus. Entropy is a better out-of-sample predictor of market returns than a collection of standard measures. Cross-sectional entropy exposure carries a negative risk premium, suggesting that assets that positively covary with entropy hedge the aggregate risk associated with shifting news language. Entropy risk cannot be explained by existing long-short factors

Collateralized networks

This paper studies the spread of losses and defaults in financial networks with two interrelated features: collateral requirements and alternative contract termination rules. When collateral is committed to a firm’s counterparties, a solvent firm may default if it lacks sufficient liquid assets to meet its payment obligations. Collateral requirements can thus increase defaults and payment shortfalls. Moreover, one firm may benefit from the failure of another if the failure frees collateral committed by the surviving firm, giving it additional resources to make other payments. Contract termination at default may also improve the ability of other firms to meet their obligations through access to collateral. As a consequence of these features, the timing of payments and collateral liquidation must be carefully specified to establish the existence of payments that clear the network. Using this framework, we show that dedicated collateral may lead to more defaults than pooled collateral; we study the consequences of illiquid collateral for the spread of losses through fire sales; we compare networks with and without selective contract termination; and we analyze the impact of alternative resolution and bankruptcy stay rules that limit the seizure of collateral at default. Under an upper bound on derivatives leverage, full termination reduces payment shortfalls compared with selective termination

Connecting discrete and continuous path-dependent options

This paper develops methods for relating the prices of discrete- and continuous-time versions of path-dependent options sensitive to extremal values of the underlying asset, including lookback, barrier, and hindsight options. The relationships take the form of correction terms that can be interpreted as shifting a barrier, a strike, or an extremal price. These correction terms enable us to use closed-form solutions for continuous option prices to approximate their discrete counterparts. We also develop discrete-time discrete-state lattice methods for determining accurate prices of discrete and continuous path-dependent options. In several cases, the lattice methods use correction terms based on the connection between discrete- and continuous-time prices which dramatically improve convergence to the accurate price.Peer Reviewedhttp://deepblue.lib.umich.edu/bitstream/2027.42/42332/1/780-3-1-55_90030055.pd