Neural Networks for Portfolio-Level Risk Management: Portfolio Compression, Static Hedging, Counterparty Credit Risk Exposures and Impact on Capital Requirement (2402.17941v1)

Abstract: In this paper, we present an artificial neural network framework for portfolio compression of a large portfolio of European options with varying maturities (target portfolio) by a significantly smaller portfolio of European options with shorter or same maturity (compressed portfolio), which also represents a self-replicating static hedge portfolio of the target portfolio. For the proposed machine learning architecture, which is consummately interpretable by choice of design, we also define the algorithm to learn model parameters by providing a parameter initialisation technique and leveraging the optimisation methodology proposed in Lokeshwar and Jain (2024), which was initially introduced to price Bermudan options. We demonstrate the convergence of errors and the iterative evolution of neural network parameters over the course of optimization process, using selected target portfolio samples for illustration. We demonstrate through numerical examples that the Exposure distributions and Exposure profiles (Expected Exposure and Potential Future Exposure) of the target portfolio and compressed portfolio align closely across future risk horizons under risk-neutral and real-world scenarios. Additionally, we benchmark the target portfolio's Financial Greeks (Delta, Gamma, and Vega) against the compressed portfolio at future time horizons across different market scenarios generated by Monte-Carlo simulations. Finally, we compare the regulatory capital requirement under the standardised approach for counterparty credit risk of the target portfolio against the compressed portfolio and highlight that the capital requirement for the compact portfolio substantially reduces.