25/3/2011

Risk Latte - All About the Cholesky Ma

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Risk Latte - All About the Cholesky Ma

Risk Latte All About the Cholesky Matrix

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25/3/2011

Risk Latte - All About the Cholesky Ma

Team Latte Aug 09, 2005

More From Articles Installment Warrant Valuation using Gaussian Quadrature Methods From Stochastic Variance to Stochastic Volatility - Another look at the Heston's Process Laplace Transforms and the Time Value of Money - I Levy Processes for valuation of Equity & FX Derivatives - Explaining the fat tails

Quantitative Finance FE Problem Sets Does it Matter Financial Derivatives Portfolio Analysis Features The Brave Economist On A Tangent Exotics The Analyst Simply Complex Brownian Motion In almost all of our training programmes where we have used Monte Carlo simulation technique to either price a multi asset product or a structure or do a value at risk (VaR) analysis, we have been quizzed extensively by our trainees on the concept of Cholesky matrix.

Cholesky decomposition method is a important technique for carrying out Monte Carlo simulation on assets and risk factors and it is certainly far easier to implement - in an code (Excel/VBA, C++, etc.) as well as to understand mathematically. It is certainly easier to understand (at least we feel so) than say, eigenvalues and eigenvectors analysis which is another way of doing Monte Carlo simulation.
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25/3/2011

Risk Latte - All About the Cholesky Ma

In one of our training session, a trainee, with a formal mathematics and physics background challenged the cholesky decomposition method and instead wanted us to go the PCA (eigenvalues & eigenvectors) route for simulating a family of risk factors. We complied with him and carried out the MC simulation schedule using PCA. Afterwards, we used cholesky method as well - using the real life correlations and volatilities in the variance-covariance matrix - and compared the results. The results were more or less same and it took far less time to implement a cholesky decomposition than it took us to do the PCA (using Jacobi method to find the eigenvalues and eigenvectors). But what was more important was that other trainees from the same group, with lesser or no formal mathematics background, appreciated the Cholesky method more. It was far more intuitive!

So, what is this Cholesky matrix?

A cholesky is a matrix A such that A times its transpose is equal to the variance covariance matrix. Or more formally, if is the variance covariance matrix then cholesky matrix A, by construction is:

AAT =

Finding the elements of A is simple matrix algebra and is almost trivial if A is say, a 2 X 2 or 3 X 3 in dimension. Even for higher dimensions, say a 10 X 10 or a 50 X 50, A can be easily estimated by writing a simple code in VBA.

The problem is that most finance textbooks, including the good ones, delve too much into the algebraic decomposition of A (cholesky matrix) and relate it to the stochastic processes for the assets (or risk factors). This, to some, at least the ones who are not mathematically motivated, makes cholesky a mental block.

That needn't be the case. We believe that if you cannot intuitive understand a mathematical concept then it is pointless to apply it to a model and simply get some results.

If you look at the above simple mathematical equation, you will see that, in matrix notation, Cholesky matrix, A, is simply a square root matrix. It is the square root matrix of the VCV (variance covariance) matrix . This is the intuitive explanation of Cholesky matrix. In a single asset (or a single risk factor) case, the formal as well as workable measure of risk is the volatility and not the variance of the asset. It is the volatility that goes as an input in the fundamental stochastic equation for an asset (along with the mean, but the mean is not a risk measure and under random walk scenario the mean drops out of the stochastic price equation).

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Risk Latte - All About the Cholesky Ma

Volatility is the sole and fundamental measure of risk of an asset (or a risk factor). For the two or more asset case, variance of an asset is replaced by the variance-covariance matrix (VCV). But since VCV contains the square terms, a square root (matrix) needs to be calculated for VCV so that the measure of risk is standardized just like the single asset case.

This square root matrix is the Cholesky matrix.

Disclaimer "Risk Latte uses proprietary and non-proprietary mathematical and empirical models to measure the volatility and estimate the direction of the market. There is no guarantee of any particular outcome happening and readers must exercise caution while interpreting the conclusions of this article. Risk Latte Company is not a registered stock broker or an SFC registered entity and readers must take advise from their financial advisors, stock brokers, research analysts and bankers while making any buying or selling decisions. Risk Latte Company is not in the business of making stock or asset forecasts whether explicitly or implicitly and shall not be responsible for and/or liable for any losses arising out of any trading decisions based on the above article."

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