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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

http://ssrn.com/abstract=2403067 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