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WEBINAR - Estimation of Real World Drift in Interest Rates and Credit Spread using Local Price of Risk by Alexander Sokol


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Presenter: Alexander Sokol: Head of Quant Research, CompatibL

Estimation of Real World Drift in Interest Rates and Credit Spread using Local Price of Risk

*Includes material from a recent paper by Hull, Sokol, and White and Risk Magazine, October, 2014

  • The estimation of real world drift in interest rates and credit spread is usually based on ad-hoc techniques or expert opinion
  • The popular ad-hoc techniques include assuming zero real world drift or substituting the risk neutral drift for the real world drift
  • Both ad-hoc techniques can cause large backtest errors which we will demonstrate on several realistic portfolios
  • We will then review a simple, practical, and non-subjective method of estimating the real world drift from the historical data
  • The method is based on a new concept of “local price of risk”
  • The relationship between local price of risk and market price of risk is similar to the relationship between local volatility and market implied volatility
  • The new method is shown to significantly improve backtest accuracy in models for limits, liquidity, and regulatory capital


XVA & Risk Management

Published date

7 November 2014



Presenter Bio

Alexander Sokol

Alexander Sokol is CEO and Head of Quant Research at CompatibL and the author of the upcoming book “Long Term Portfolio Simulation”, to be published by Risk Books in 2014.

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