Risk Scenario

Assess the consequences of virtually any market situation on your portfolio.

As an unparalleled risk simulation software module, the LexiFi Risk Scenario feature allows the assessment of the impact of virtually any quantifiable market shock on the price of an individual structured product or portfolio. The Risk Scenario simulation starts by filling in LexiFi Apropos’s extremely functional trading-quality entry screens and this entire simulation can be automated using LexiFi’s standard tools. The intuitiveness and the power of this feature originate in the combination of LexiFi’s comprehensive list of models eligible for each simulation and a limited amount of uncomplicated operators unlocking an infinite diversity of scenarios. The process of filling in the entry screen can also be simplified by selecting common built-in and user-defined scenarios from “Reference”. This contributes to one of LexiFi Apropos’s general objectives: considerably reduce input capture time.

Concretely, the user begins by defining scenarios, which can be done by browsing the drop-down menu of “Scenario parameters”, and, one click on the “Calculate” button later, LexiFi Apropos executes them as if they all occurred instantaneously. For each scenario defined, the software returns the price of the product or of a portfolio of products, and a price difference with the initial price of the product or portfolio. The similarity with the output of the pricing function clarifies Risk Scenario’s dependency on the pricing engine.

Video 1: General presentation of Risk Scenario


Risk Scenario offers immeasurable flexibility for the creation of scenarios. All scenarios are founded upon “bricks”. These bricks help to create and regroup different shocks (intuitively, small scenarios) within one scenario.

The first brick can be considered as the most elementary but also as the most specific type of scenario. It consists in one particular shock to one particular market data item from the spot (the initial) market data environment (a set of market data items), the magnitude of the shock and the specific methodology being set by the user, with specific syntax. In LexiFi Apropos, this brick is the “Explicit” parameter. A shock to ALL market data items of a given market data environment can be performed with “Transformation”, with which the user defines the shock to apply using simple syntax, identical to the one required for “Explicit”. “Transformation” can be interpreted as an extension of “Explicit”. “Explicit” and “Transformation” make the production of entirely new scenarios possible, and these scenarios can be stored in “Reference” for later shared use. Entirely personalized baseline scenarios can thus be obtained. Additional scenarios may be written using these baseline scenarios, useful both for the transformation of market data items and of valuation dates.

Partitioners constitute the second brick used to define most scenarios. They correspond to “For all/each”, a feature easily found in the “Scenario parameters” menu. The role of this feature is to separate the market data items of the initial market data environment into different subsets and apply transformations onto the items of the different subsets in different ways. Exactly the same scenarios (as in the general case) can be defined with “For all/each”, except that the scenarios are applied either simultaneously or individually to the appropriate sub-environments. With partitioners, the user can decide to apply shocks to all the items of a specific type at the same time (“For all”) or on each of them individually (“For each”), according to the partition selection.

An essential scenario parameter that could be considered almost as complementary or even unseparable from the partitioner “For all/each” is “From…to…in…steps transformations”, the third brick, also available in the “Scenario parameters” menu. While “For all/each” partitions environments, “From…to…in…steps transformations” defines the number of shocks to regroup in one single scenario. LexiFi Apropos will shock the quotes of all the items of a given environment from the lower bound to the upper bound of the predefined range in the number of steps chosen.

Scenarios can then be combined in different ways. The user is free to choose the scale of her approach, from a micro focus, based on a small number of precise situations to a very broad macro view, characterized by a large amount of shocks. The more macro approach can be illustrated by combining many scenarios. There are precisely three tools to combine scenarios, representing the last main brick, called combinators: “Union”, “Compose” and “Sequence”. The simplest combinator is “Union”: it orders LexiFi Apropos to execute each scenario from the spot following the order of the list of defined scenarios.

Video 2: Introducing the “Union” combinator


The “Compose” combinator, technically, produces the “cartesian product” of the listed scenarios. This combinator and the “cartesian product” are best explained by the following video:

Video 3: The “Compose” combinator


The third combinator, “Sequence”, can be seen as a mix of “Union” and “Compose”. “Sequence” is the “Union” of: the first scenario of the list, the “Compose” of the first and the second scenario, and the “Compose” of the first, second and third scenarios, etc. Differently from “Union” and “Compose”, the order of the listed scenarios matters with “Sequence”.

Risk Scenario offers the possibility to simulate complex situations of interest to clients using a small amount of very simple operators. The first key situation considered is the yield curve transformation. “Nonparallel yield curve shift” is a dedicated scenario parameter. Rates are shocked according to their maturities. The user can set a maturity in terms of days, months, years, or alternatively set a specific date in the calendar. This scenario parameter enables the creation of customized yield curve transformations, one maturity at a time. A possible transformation would thus be a yield curve inversion, a phenomenon that has preceded every U.S. recession for the past 60 years, according to research from the Federal Reserve Bank of San Francisco (1). The simplicity and the flexbility when simulating such an event is striking: the user just needs to increase the short-term rates of his preference by more than longer-term rates (or decrease the long-term rates). The flexibility resides in the fact that both the maturities and the magnitudes of the shocks are selected and set by the user.

Video 4: Yield curve transformations with Risk Scenario


Another parameter related to the shock of rate maturities is “Rate buckets”: the aim of this parameter is to shock rates from defined maturity intervals, according to one (or several) scenario(s) defined within “Rate buckets”.

The second key situation would be a stress test scenario, possibly occuring at times of economic and/or financial crises. The aim is simply to shock quotes according to different magnitudes, depending on the simulated situation. Risk Scenario’s strength here is that it comprises all the bricks to:

  • Shock quotes according to specific magnitudes by using “Explicit” for example

  • Define different magnitudes depending on different market data items. Again, “Explicit” is an adequate brick to do so

  • Partition the market data environment to choose which items to shock and which to leave aside, with, naturally, the partitioner “For all/each”

  • Create a sequence of absolute or relative shocks with “From…to…in…steps transformations”

  • Combine stress tests in three different ways with combinators. LexiFi Apropos merges such stress tests with other scenarios, such as interest rate increases, in a both simple and coherent way.

LexiFi knows that the quality of the results of data analysis is paramount. Additionally to prices and price differences, other valuable results are unlocked by ticking the “Keep individual pricing results” box, present by default on the Risk Scenario page. For each scenario defined, a pop-up window is opened by double-clicking on the corresponding cell in the “Pricing result” column of the pricing results table. The valuation date, the price, the model kind and information on the “Bid/Ask” is displayed. The user also has access to an audit trail, information regarding different dates relevant to the pricing, properties, market data items, market data transformations and model parameters. What is special here is that this bottomless volume of data and results is stored for every single shock, regardless of its magnitude and the number of market data items it covers. The feature also displays a more concise summary of the shock of market data items, triggered by a double click on any cell of the first column of the pricing results table. Again, a pop-up window appears, containing an exhaustive comparison of the transformations of the main types of market data items affected by the scenarios created. There are two tables: the first compares the “New” (shocked) quotes of the items to the initial (spot) ones, corresponding to the product or the portfolio of interest before the running of the simulation. The second table compares shocked values to the quotes modified by the previous scenario in the list of scenarios defined (this assumes the existence of at least two scenarios). LexiFi’s philosophy centered around perpetual reduction of pricing time is embodied by its “Run parallel scenario pricing” box: when scenarios lead to the same computations, LexiFi Apropos executes these only once, to reduce pricing time, crucial to the industry’s professionals.

The incredible connectivity of the functionality is epitomized by its “Excel scenario file” parameter, enabling the import of scenarios from Excel files. Alongside “Explicit”, the other way to define scenarios in a generic way is by using a specific format on an Excel file.

Once that the pricing has taken place, it is possible to further choose the results displayed, other than with “Keep individual pricing results”. For any combination of scenarios, with one click on the “Draw price chart” button, or with “Draw diff chart”, the user obtains charts and tables summarizing in a clear and readable way the pricing results. For both prices and price differences, it is also possible to draw charts only for selected rows of the pricing results table. LexiFi Apropos can also save results with “Save as pricing result”, for later use.

There is also an astonishing connection between Risk Scenario and the Document Generation feature: all pricing results obtained with Risk Scenario, from audit trails to individual market data items shocked by the running of one among many scenarios, are automatically transferred and made available to LexiFi Apropos’ document generator. Given the importance of clear communication of stress test results, again in just one click, LexiFi Apropos can offer complete customization of specific documents, exportable in HTML or PDF formats and readily exploitable by clients. The connection with the software’s other preeminent feature opens the door to an unlimited amount of document personalization to present scenario results.

Video 5: Stress tests and the drawing of charts


A major takeaway of this presentation is that LexiFi Risk Scenario offers a functionality that allows the definition of complex scenarios and the evaluation of their impact on prices of derivatives and structured products with a reduced number of simple operators, or “bricks”. There is one brick to create virtually any scenario (“Explicit”), only one to partition environments (“For all/each”), relying on another essential tool (“From…to…in…steps transformations”) and just three bricks to combine scenarios in an almost infinite number of ways (“Union”, “Compose” and “Sequence”). There are also just two operators to define yield curve transformations (“Nonparallel yield curve shift” and “Rate buckets”). The software also “naturally” adapts to the types of market data items treated and/or scenarios defined. Repetitions are always avoided, whether these are calculation repetitions, with “Run parallel scenario pricing” to reduce the time required to return pricing results, or more structural repetitions. This is one among many obstacles automatically detected by the software, pursuing LexiFi’s tradition of clarity and simplicity, reflected even in the structure and the functioning of the Modeling Language for Finance (MLFi). The entire Risk Scenario user experience, from data entry to result analysis, is subsequently made as straightforward as possible.

More than 10 years of client feedback suggests that no other software can offer such highly important results at this speed, in such a simple and tailored way. The unmatched power of LexiFi Risk Scenario resides in the software’s capacity to execute any list of combined scenarios, whatever its length and size, which could consist in a set of baseline scenarios, coupled with a quasi-infinite level of user customization.

Sources

(1): https://www.frbsf.org/economic-research/files/el2018-07.pdf

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