208 research outputs found
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
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
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