Free Download Market Consistency: Model Calibration in Imperfect Markets By Malcolm Kemp
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DESCRIPTION
Achieving consistent alignment with market realities is a challenge—even for highly experienced finance professionals. In Market Consistency: Model Calibration in Imperfect Markets, noted expert Malcolm Kemp provides a clear roadmap for integrating market-consistent principles across all areas of finance. Drawing on decades of practical experience as a practitioner, writer, and speaker, Kemp examines how risk management and related disciplines are evolving as fair valuation becomes increasingly central to both financial practice and regulatory frameworks.
This is the only resource that methodically demonstrates how to calibrate risk, pricing, and portfolio construction models to a truly market-consistent standard. Kemp guides readers through when and how such consistency should be applied, its implications for various financial fields, and how to achieve it for both liquid and illiquid assets. He addresses why perfect market consistency is sometimes impossible—particularly in areas like hedging parameter calculation—and offers practical solutions to these complex challenges.
The book also explains how to mark-to-market illiquid positions and integrate these valuations into solvency assessments and other forms of financial analysis. It outlines ways to determine and define risk-free interest rates, even in environments where sovereign credit quality is no longer unquestioned. Additionally, it clarifies when market consistency should be a primary focus, and when clients or employers might place less weight on it.
Finally, Kemp explores the regulatory and risk management landscape across different sectors of the financial industry—highlighting why market consistency is crucial for insurers, pension funds, banks, and asset managers, while recognizing that optimal solvency approaches may differ significantly between these groups.
ABOUT THE AUTHOR
Malcolm Kemp is a distinguished actuary and authority in risk and quantitative finance, with more than 25 years in the financial services sector. From 1996 to 2009, he led Quantitative Research at a major UK investment management firm, following a role as a partner in an actuarial consultancy. He is currently Managing Director of Nematrian Limited.
TABLE OF CONTENTS
Preface.
Acknowledgements.
Abbreviations.
Notation.
1 Introduction.
1.1 Market consistency.
1.2 The primacy of the ‘market.
1.3 Calibrating to the ‘market’.
1.4 Structure of the book.
1.5 Terminology.
2 When is and when isn’t Market Consistency Appropriate?
2.1 Introduction.
2.2 Drawing lessons from the characteristics of money itself.
2.3 Regulatory drivers favouring market consistent valuations.
2.4 Underlying theoretical attractions of market consistent valuations.
2.5 Reasons why some people reject market consistency.
2.6 Market making versus position-taking.
2.7 Contracts that include discretionary elements.
2.8 Valuation and regulation.
2.9 Marking-to-market versus marking-to-model.
2.10 Rational behaviour?
3 Different Meanings given to ‘Market Consistent Valuations’.
3.1 Introduction.
3.2 The underlying purpose of a valuation.
3.3 The importance of the ‘marginal’ trade.
3.4 Different definitions used by different standards setters.
3.5 Interpretations used by other commentators.
4 Derivative Pricing Theory.
4.1 Introduction.
4.2 The principle of no arbitrage.
4.3 Lattices, martingales and Îto calculus.
4.4 Calibration of pricing algorithms.
4.5 Jumps, stochastic volatility and market frictions.
4.6 Equity, commodity and currency derivatives.
4.7 Interest rate derivatives.
4.8 Credit derivatives.
4.9 Volatility derivatives.
4.10 Hybrid instruments.
4.11 Monte Carlo techniques.
4.12 Weighted Monte Carlo and analytical analogues.
4.13 Further comments on calibration.
5 The Risk-free Rate.
5.1 Introduction.
5.2 What do we mean by ‘risk-free’?
5.3 Choosing between possible meanings of ‘risk-free’.
6 Liquidity Theory.
6.1 Introduction.
6.2 Market experience.
6.3 Lessons to draw from market experience.
6.4 General principles.
6.5 Exactly what is liquidity?
6.6 Liquidity of pooled funds.
6.7 Losing control.
7 Risk Measurement Theory.
7.1 Introduction.
7.2 Instrument-specific risk measures.
7.3 Portfolio risk measures.
7.4 Time series-based risk models.
7.5 Inherent data limitations applicable to time series-based risk models.
7.6 Credit risk modelling.
7.7 Risk attribution.
7.8 Stress testing.
8 Capital Adequacy.
8.1 Introduction.
8.2 Financial stability.
8.3 Banking.
8.4 Insurance.
8.5 Pension funds.
8.6 Different types of capital.
9 Calibrating Risk Statistics to Perceived ‘Real World’ Distributions.
9.1 Introduction.
9.2 Referring to market values.
9.3 Backtesting.
9.4 Fitting observed distributional forms.
9.5 Fat-tailed behaviour in individual return series.
9.6 Fat-tailed behaviour in multiple return series.
10 Calibrating Risk Statistics to ‘Market Implied’ Distributions.
10.1 Introduction.
10.2 Market implied risk modelling.
10.3 Fully market consistent risk measurement in practice.
11 Avoiding Undue Pro-cyclicality in Regulatory Frameworks.
11.1 Introduction.
11.2 The 2007-09 credit crisis.
11.3 Underwriting of failures.
11.4 Possible pro-cyclicality in regulatory frameworks.
11.5 Re-expressing capital adequacy in a market consistent framework.
11.6 Discount rates.
11.7 Pro-cyclicality in Solvency II.
11.8 Incentive arrangements.
11.9 Systemic impacts of pension fund valuations.
11.10 Sovereign default risk.
12 Portfolio Construction.
12.1 Introduction.
12.2 Risk-return optimisation.
12.3 Other portfolio construction styles.
12.4 Risk budgeting.
12.5 Reverse optimisation and implied view analysis.
12.6 Calibrating portfolio construction techniques to the market.
12.7 Catering better for non-normality in return distributions.
12.8 Robust optimisation.
12.9 Taking due account other investors’ risk preferences.
13 Calibrating Valuations to the Market.
13.1 Introduction.
13.2 Price formation and price discovery.
13.3 Market consistent asset valuations.
13.4 Market consistent liability valuations.
13.5 Market consistent embedded values.
13.6 Solvency add-ons.
13.7 Defined benefit pension liabilities.
13.8 Unit pricing.
14 The Final Word.
14.1 Conclusions.
14.2 Market consistent principles.
Bibliography.
Index.
SERIES
The Wiley Finance Series
