Simulation in the Real World

17 Pages Posted: 31 Aug 2016

See all articles by Russell Barker

Russell Barker

Independent

Andrew Samuel Dickinson

Bank of America

Alex Lipton

Hebrew University of Jerusalem; Massachusetts Institute of Technology (MIT)

Date Written: August 30, 2016

Abstract

In this paper, we propose two practicable approaches for consistently modelling the realworld and risk-neutral measures within cross-asset Monte-Carlo frameworks. We go on to explore the necessity of supporting the real-world measure and consider its calibration with the aid of an explicit example of a 3-factor Hull-White model exhibiting the volatility hump and roll-down effect. This example parallels the 1-factor lattice model considered in Hull, Sokol and White, however, allows risk-premia which are stable through time and illustrates the necessity of having a sufficiently rich correlation structure in order to produce realistic dynamic risk-premia.

Keywords: Asset Pricing, Risk Management, Risk-Neutral Pricing, Term Structure of Interest Rates, Esscher Transform

JEL Classification: C02, C15, C51, C58, C63, G12, G13

Suggested Citation

Barker, Russell and Dickinson, Andrew Samuel and Lipton, Alex, Simulation in the Real World (August 30, 2016). Available at SSRN: https://ssrn.com/abstract=2831726 or http://dx.doi.org/10.2139/ssrn.2831726

Russell Barker

Independent ( email )

Andrew Samuel Dickinson (Contact Author)

Bank of America ( email )

2 King Edward Street
London, EC1A 1HQ
United Kingdom

Alex Lipton

Hebrew University of Jerusalem ( email )

Mount Scopus
Jerusalem, Jerusalem 91905
Israel

Massachusetts Institute of Technology (MIT) ( email )

77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States

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