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Slides Denev

Probabilistic Graphical Models (PGMs) provide a graphical representation of random variables and their conditional independencies, which can be applied to financial networks to model interactions among firms. Various types of PGMs, such as Bayesian Nets and Markov Random Fields, can be utilized to analyze financial data, including probabilities of default and asset returns. The document discusses the calibration of these models and their ability to compute systemic risk indicators and distributions of losses in financial systems.

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5 views21 pages

Slides Denev

Probabilistic Graphical Models (PGMs) provide a graphical representation of random variables and their conditional independencies, which can be applied to financial networks to model interactions among firms. Various types of PGMs, such as Bayesian Nets and Markov Random Fields, can be utilized to analyze financial data, including probabilities of default and asset returns. The document discusses the calibration of these models and their ability to compute systemic risk indicators and distributions of losses in financial systems.

Uploaded by

mashaozhi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Financial Networks as

Probabilistic Graphical
Models (PGM)
CAMBRIDGE, SEPTEMBER 2015
What PGMs are

 A set of random variables can be given a graphical representation which


encodes the conditional independencies between them in a visually
appealling form
 The name of this representation is Probabilistic Graphical Models (PGM)
 A graphical representation consists of
 Nodes – the random variables
 Edges – the probabilistic interactions between them
A short taxonomy

 There are many types of Probabilistic Graphical Models


 Some of them are suitable for studying networks of firms such as:
 Bayesian Nets (BN)
 Markov Random Fields (MRF)
 Chain Graphs (CG)
 Directed Cyclic Graphs (DCG)
Probabilistic Graphical Models

Markov Random Field (MRF) Bayesian Net (BN) Chain Graph (CG)
(B ⊥ C | A, D)1
(D ⊥ A | B,C) (B ⊥ C | A), D D
A (C ⊥ D | A),
(B ⊥ D | A)
B C A A

D B C B C

Chain Component
The set of variables which remain connected (B , C ⊥ D | A)
1. The symbol ⊥ denotes independence relationship by undirected edges after removing the
The symbol | denotes “given”. We more compactly want directed edges
to say B is independent of C given A and D NB Also D and A are chain components formed
each by 1 node
PGM and Financial Networks

 The nodes in a PGM can represent random variables characterising a set


of financial firms and the edges how these variables influence each other
 Typical examples of random variables are:
 Probabilities of default
 Asset returns
 Equity returns
 Etc
MRF and Default Configurations

 A network of firms resembles (with an


oversimplification) a grid of atoms whose debt
interactions are, on the face of it, similar to the those of
the Ising model usually modelled through a MRF
 In such a description, firms themselves (and the
interactions between them) can be seen as atoms,
where the default of a set of debtors to firm i can “flip”
i into default
 MRFs provide a natural representation of a network of
debt relations, as they are endowed with desirable
screening properties. In fact, if two firms are not
indebted with each other, we have no reason to
believe that they should exert any direct influence on
each other’s probability of default
PGM and Networks of Defaults

Markov Random Field (MRF) representation of a network of probabilities of default

PD3
PD1 PD2
Debt Relationhsips

PD4
PD7
PD5
PD6
Populating the MRF

 When specifying a MRF we must define the affinity between the two
variables and we shall do this through a potential ϕ(A, B)
 A potential is a positive real-valued function over a discrete domain Ω
ϕ(Ω): Ω → R+
 For the boolean MRF below we have to define four values for the potential
ϕ(A, B), ϕ(nA, B), ϕ(A, nB) and ϕ(nA, nB)

Example
𝐴 B 50
𝐴 𝐵 10
A B 𝐴 𝐵 20
𝐴 𝐵 1
Normalizing

 The joint probability is given by:

1
𝑃 𝐴, 𝐵 = 𝜑(𝐴, 𝐵)
𝑍
 With the normalization constant:
𝑍= 𝜑(𝐴, 𝐵)
𝐴,𝐵

Example: Joint Probability Table


𝐴 𝐵 61.7%
𝐴 𝐵 12.3%
𝐴 𝐵 24.7%
𝐴 𝐵 1.2%
The Joint Probability Table

 When extending to more complex networks what we need to provide is


only the potential encoding the interaction of a random variable with its
neigbors
 From local assignments of potentials we build a global characterization of
the network given by the joint probability table
Example: JPT for 3 nodes
Calibration

 Such network can be calibrated by knowing 2 sets of quantities


 For each 𝑋𝑖 the marginal probability 𝑃(𝑋𝑖 )
 For each pair 𝑖, 𝑗 the correlation ρ(𝑋𝑖 , 𝑋𝑗 )
 Or:
 For each 𝑋𝑖 the marginal probability 𝑃(𝑋𝑖 )
 For each pair 𝑖, 𝑗 the joint probability 𝑃(𝑋𝑖 , 𝑋𝑗 )
 Or:
 For each 𝑋𝑖 the marginal probability 𝑃(𝑋𝑖 )
 For each pair 𝑖, 𝑗 the conditional probability 𝑃(𝑋𝑖 |𝑋𝑗 ) (or 𝑃(𝑋𝑗 |𝑋𝑖 ))
Distribution of Defaults

 Once the network is calibrated then a network default distribution can be


calculated
Distribution of Losses

 …and a distribution of losses in the system


Distribution of Losses

 Systemic risk indicators can be computed from the distribution of losses


e.g.:
 VaR
 Conditional VaR
 The contribution of a single firm to the the distribution of losses can be
measured as:
𝑁
 Component VaR (𝑉𝑎𝑅 = 𝑖=1 𝑉𝑎𝑅𝑖 )
𝑁
 Component Conditional VaR (𝐶𝑉𝑎𝑅 = 𝑖=1 𝐶𝑉𝑎𝑅𝑖 )
Other Networks

 The previous setup assumes that the structure of default relationships


between firms is known
 Sometimes obtaining such information may be very difficult even for
central banks
 Other types of network relationships can be still studied e.g. equity returns
Training a Continuous MRF

 If a variable in a network represents


the equity return of a firm one can
train a MRF on a dataset containing
the equity returns of a set of firms1
 The learning algorithm will
automatically find the conditional
independencies and detect the
significant edges
 One can then transform the equity
returns in network default
probabilities by introducing a default
threshold and discretising
1 An example from Ahelegbey and Giudici (2014)
Reducing the network

 One can condition the equity


returns on a global market risk
factor (e.g. the S&P 500 or a
liqudity index) and train a PGM
on the returns residuals which
are non-explained by the risk
factors
 The number of links is greatly
reduced but not eliminated
A chain graph approach

 The example of the two


previous slides are essentially a
Chain Graph PGM

A Chain Graph of 3 factors F={F1,F2,F3} and 3 firms C={C1,C2,C3}


A Bayesian Net approach

 As an alternative one can


choose to train a Bayesian Net
on the firms’residuals as done in
Kitwiwattanachai (2014) on CDS
data of large banks

Δ𝑙𝑜𝑔𝑆𝑖,𝑡 = 𝛼𝑖 + 𝛽𝑚 𝑅𝑚,𝑡 + 𝛽𝑣 Δ𝑉𝐼𝑋𝑡 + 𝜀𝑖,𝑡

where Δ denotes weekly changes of


the CDS 𝑆𝑖,𝑡 of institution 𝑖, 𝑅𝑚,𝑡 is the
S&P500 weekly returns at time t,
and VIX is the CBOE implied volatility index
Conclusions

 PGMs are a good framework to modelling financial networks as they can


take into account the inherent stochasticity of complex systems of
interacting entities
 PGMs can express conditional independencies as the ones observed in
real network of interacting entities
 PGMs can be trained automatically on data to unveil the underlying
structure of the network at hand
Books

Portfolio Management under Stress


A Bayesian Net Approach to Coherent Asset Allocation
Riccardo Rebonato, Alexander Denev

Probabilistic Graphical Models in Finance


Alexander Denev

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