## Archive for **December 13th, 2009**

## Heading off to AFBC 2009

I am on my way to the 22nd Australasian Finance and Banking Conference 2009 in Sydney. So, what the hell, is a mathematician doing on a finance conference? Well, basically mathematics and in particular optimization and operations research. I am thrilled to see the current developments in economics and finance that take computational aspects, which ultimately limit the amount of rationality that we can get, into account (I wrote about this before here, here, and here). In fact, I am convinced that these aspects will play an important role in the future, especially for structured products. After all, who is going to buy a structure where it is impossible to compute the value? Not even to talk about other complications such as bad data or dangerous model assumptions (such as static volatilities and correlations which are still used today!). Most valuation problems though can be cast as optimization problems and especially the more complex structured products (e.g., mean variance optimizer) do explicitly ask for a solution to an optimization problem in order to be valuated. For the easier structures, Monte Carlo based approaches (or bi-/trinomial trees) are sufficient for pricing. As Arora, Barak, Brunnermeier, and Ge show in their latest paper, for more complex structures (e.g., CDOs) these approaches might fall short capturing the real value of the structures, due to e.g., deliberate tampering.

I am not going to talk about aspect of computational resources though: I will be talking about my paper “Optimal Centralization of Liquidity Management” which is joined work with Christian Schmaltz from the Frankfurt School of Finance and Management. The problem that we are considering is basically a facility location problem: In a large banking network, where and how do you manage liquidity? In a centralized liquidity hub or rather in smaller liquidity centers spread all over the network. Being short on liquidity is a very expensive matter, either one has to borrow money via the interbank market (which is usually dried up or at least tight in tougher economical conditions) or one has to borrow via the central bank. If both is not available, the bank goes into a liquidity default. The important aspect here is that the decision on the location and the amount of liquidity produced, is driven to a large extent by the liquidity demand volatility. In this sense a liquidity center turns into an option on cheap liquidity and in fact, the value of a liquidity center can be actually captured in an option framework. The value of the liquidity center is the price of the exact demand information – the more volatility we have, the higher this price will be and the more we save when we have this information in advance. The derived liquidity center location problem implicitly computes the prices of the options which arise as marginal costs in the optimization model. Here are the slides: