In this research paper, Andrew McClelland PhD and Financial Engineering specialist at Numerix, examines the differences between risk-neutral dynamics and real-world dynamics, and the important role of risk premia. The paper explores why real-world dynamics are necessary for risk analysis and scenario generation, and also discusses the roles of the equity premium and volatility premium in stochastic volatility models of equity markets.
Highlights include:
- Real-world Dynamics vs. Risk-neutral Dynamics
- Defining Risk-neutral Dynamics
- Defining Real-world Dynamics
- Implications for Risk Profiles and Scenarios
- Impact on Variable Annuities & Structured Derivatives
- Stochastic Volatility and The Volatility Premium
- Best Practices for Process Re-engineering and Implementation
- Best Practices for Visualizing EVA
- Why Real-world Profiles Can Deviate from Risk-neutral Profiles
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About the Author:
Andrew McClelland, PhD, Financial Engineering, Numerix
Andrew McClelland’s work at Numerix focuses on counterparty credit risk issues including valuation adjustments and counterparty exposure production for structured products, and numerical methods for efficient production of risk profiles under the real-world measure.
Dr. McClelland earned his PhD in finance at the Queensland University of Technology for a thesis on financial econometrics. He considered markets exhibiting crash feedback, option pricing for such markets, and parameter estimation for such markets using particle filtering methods. His work has been published in the Journal of Banking and Finance and the Journal of Econometrics.
