NON-LINEAR WORLD LINEAR MODELS

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Nasir Afaf, CQF Lecture, April 2007 - redesign ICBI May 2008. Pyramid of Modern Finance . Nasir Afaf, CQF Lecture, April 2007 - upgrade ICBI May 2008. Genuine Markets. Distinctive classes of business sector participantsCharacterised by differentEnd objectivesTime horizonsRisk appetiteResponse to market elements.

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NON-LINEAR WORLD LINEAR MODELS? Nasir Afaf Disclaimer: The perspectives communicated here are those of the creator and not Commerzbank AG Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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Pyramid of Modern Finance Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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Real Markets Different classes of market members Characterized by various End goals Time skylines Risk craving Response to market progression Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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Market Participants Corporates – hedgers Market making foundations Investors: Hedge stores/Proprietary Trading Desks Real cash supervisors – resource chiefs, benefits reserves and so forth CTA's Retail Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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Market Participants Behavior Equity Smile Example Equity Skew for drawback is methodical hazard premium for financial specialists holding fundamentally long positions. Value Sell off would trigger stop misfortunes, and a snappy down move. Hence premium for drawback puts Skew stays offer for drawback regardless of the possibility that value markets slant upward, so not a measurable indicator of future moves, rather a descriptor of torment edges Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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Market Participants Behavior FX "Convey" Smile illustration "Convey" merchants hope to gain higher yield through acquiring in low financing cost economies and storing in higher loan fee economies. Illustration EUR/TRY, with a 1y rate differential of 15% (1500bp) "Convey" merchants convey hazard that the higher yielding money debilitates – in this way chance inversions (skew) deliberately offer for solid cash calls (puts on the higher yielding money) As precise as Equity Skew. USD/JPY is the greatest illustration Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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Market Participants Behavior Equity and FX Skew Direction Comparison On a factual examination Equity and FX markets seem altogether different . Inverse headings of skew when contrasted with Forward focuses. In any case, deluding. Comprehension of both markets demonstrates that same progression offer ascent to contradicting skews. Both markets willing to pay a premium for escaping their long positions Equity financial specialists hope to profit through capital thankfulness from long value positions. Their "torment" is an auction in values – consequently ready to pay for drawback security. FX financial specialists hope to profit through "convey". Their "agony" is a debilitating of the higher yielding cash – consequently ready to pay for upside security. Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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Markets are non-direct – the feeble part Interaction among market members is critical. He (obscure) did this, so I do that… .. To see how that collaboration happens you need to see each sort of member. For instance, resource supervisors don't alter their possessions often. Certain sorts of speculative stock investments may do ("Renaissance"?) This offers ascend to value flow in here and now. Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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Markets are non-direct – the solid part Interaction is played out against a setting of liquidity, credit lines, levels of allowed hazard, presentation of new monetary instruments This creates value progression. Impeccably irregular to an unadulterated analyst with no understanding into what constitutes a market. Organized arbitrariness for an astute market member. Data and knowledge is the key. Coming about value progression firmly criticism into liquidity, credit lines, levels of allowed hazard, presentation of new budgetary instruments. This endless criticism circle is the thing that we call a market . Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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Using Derivatives Models Model to start with, or think first Linear SDE and so forth… Linear models exceedingly admired – however valuable. Least demanding to display. Genuine valuing is non-direct. Cost can never be free of hazard breaking points, and the hazard in your book. You generally need to make mental conformities. Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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So who is a Derivatives Trader Linear model Non-direct markets with input impacts Non-straight evaluating regarding mental acclimations to represent chance in book, and hazard limits and so on A subsidiaries merchant is a non-straight control procured by the bank to exchange non direct instruments esteemed utilizing direct models. This non-straight control is by and large a long way from ideal! Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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Ingredients in non-direct control Specific Mkt hazard limits Credit limits Performance year to date! Momentum book profile Availability (and comprehension!) of "valuable models" Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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Ingredients in non-direct control General (Market Specific) Regulatory system Liquidity (Depth of market) Transaction costs Aggregate "market creator" situating Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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Missing fixing in models Liquidity Derivatives Models accept a vast ocean of liquidity Economic ideas of liquidity? My idea of liquidity: All value changes are because of the recurring pattern of liquidity . It is just important to discuss liquidity at a specific value level and at a specific time. Each value development is a liquidity press. Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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Feedback impacts Feedback Derivatives Models ("no arbitrage") valuations depend on supporting formulas Superiority of a model in view of how well "formula" can be executed practically speaking Can separate items/models into various classes. Simple to fence formula ("fwd"), hard to support formula ("short date computerized"). Showcase chance total because of prevalence of items/thoughts/structures. Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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Feedback from subsidiaries "formulas" into liquidity Pyramid of current back (slide 1). Not all that restricted! Each well known item makes its own criticism Ever changing nature of liquidity, makes new open doors, and more items Sometimes most ideal approach to exchange money is to be on top of complex exotics ("know the highest point of the pyramid, exchange the base") Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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Modeling liquidity - 1 Tangible Inputs Tangibles (accessible to all) Bid-offer spreads in market Volatility levels and other such data "Ocean" of all accessible market information "Hypothesis of everything model" or particular "phenomenological demonstrate" from recognizable market information. Exchange offs between model decisions. Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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Modeling liquidity - 2 Intangibles Effective "data set" and examination Modeling "connection" Modeling non-direct criticism Distinction between market-producers and market takers. Assert: over stressed. Advertise producers are regularly showcase takers. "Stock administration" is best similarity for market making movement. Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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Successful liquidity displaying Any sensible liquidity demonstrate (understanding) must be alterable instead of static. Have the capacity to clarify some wonder not managable to customary methodologies ("astuteness" instead of "confirmation") Must then infer a dynamical articulation for value elements – and deliver watched "measurable marks" As in "chess" input and versatile reactions, strategic and key, must show up. These are subjective fixings. Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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What it comes down to Derivatives valuations can't be relied upon to be novel. Distinctive "data set", diverse "subjective investigation of collaboration", diverse "technique", for every member is critical. Dealers endeavor to "control" this non-linearity heuristically. In any event the insightful (effective?) ones do! Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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What it comes down to – BIG PICTURE All comes down to "foreseeing" and displaying Order Flow. Arrange Flow is driven by liquidity progression, which then converts into value changes. Shorter term instead of longer term situating. Demonstrating gets to be "Circumstances and end results" instead of "Visually impaired Statistical portrayals" Nasir Afaf, CQF Lecture, April 2007 - refresh ICBI May 2008

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