Author: Thijs van den Berg (Page 2 of 3)

Building Correlation Matrices with Controlled Eigenvalues: A Simple Algorithm

March 15, 2025 / Thijs van den Berg

In some cases, we need to construct a correlation matrix with a predefined set of eigenvalues, which is not trivial since arbitrary symmetric matrices with a given set of eigenvalues may not satisfy correlation constraints (e.g., unit diagonal elements).

A practical method to generate such matrices is based on the Method of Alternating Projections (MAP), as introduced by Waller (2018). This approach iteratively adjusts a matrix between two sets until convergence. It goes like this:

Faster Monte Carlo Exotic Option Pricing with Low Discrepancy Sequences

March 13, 2025 / Thijs van den Berg

In this post, we discuss the usefulness of low-discrepancy sequences (LDS) in finance, particularly for option pricing. Unlike purely random sampling, LDS methods generate points that are more evenly distributed over the sample space. This uniformity reduces the gaps and clustering seen in standard Monte Carlo (MC) sampling and improves convergence in numerical integration problems.

A key measure of sampling quality is discrepancy, which quantifies how evenly a set of points covers the space. Low-discrepancy sequences minimize this discrepancy, leading to faster convergence in high-dimensional simulations.

Finding the Nearest Valid Correlation Matrix with Higham’s Algorithm

March 12, 2025 / Thijs van den Berg

Introduction

In quantitative finance, correlation matrices are essential for portfolio optimization, risk management, and asset allocation. However, real-world data often results in correlation matrices that are invalid due to various issues:

Merging Non-Overlapping Datasets: If correlations are estimated separately for different periods or asset subsets and then stitched together, the resulting matrix may lose its positive semidefiniteness.
Manual Adjustments: Risk/assert managers sometimes override statistical estimates based on qualitative insights, inadvertently making the matrix inconsistent.
Numerical Precision Issues: Finite sample sizes or noise in financial data can lead to small negative eigenvalues, making the matrix slightly non-positive semidefinite.

Optimal Labeling in Trading: Bridging the Gap Between Supervised and Reinforcement Learning

March 10, 2025 / Thijs van den Berg

When building trading strategies, a crucial decision is how to translate market information into trading actions.

Traditional supervised learning approaches tackle this by predicting price movements directly, essentially guessing if the price will move up or down.

Typically, we decide on labels in supervised learning by asking something like: “Will the price rise next week?” or “Will it increase more than 2% over the next few days?” While these are intuitive choices, they often seem arbitrarily tweaked and overlook the real implications on trading strategies. Choices like these silently influence trading frequency, transaction costs, risk exposure, and strategy performance, without clearly tying these outcomes to specific label modeling decisions. There’s a gap here between the supervised learning stage (forecasting) and the actual trading decisions, which resemble reinforcement learning actions.

In this post, I present a straightforward yet rigorous solution that bridges this gap, by formulating label selection itself as an optimization problem. Instead of guessing or relying on intuition, labels are derived from explicitly optimizing a defined trading performance objective -like returns or Sharpe ratio- while respecting realistic constraints such as transaction costs or position limits. The result is labeling that is no longer arbitrary, but transparently optimal and directly tied to trading performance.

Efficient Rolling Median with the Two-Heaps Algorithm. O(log n)

March 10, 2025 / Thijs van den Berg

Calculating the median of data points within a moving window is a common task in fields like finance, real-time analytics and signal processing. The main applications are anomal- and outlier-detection / removal.

Fast Rolling Regression: An O(1) Sliding Window Implementation

March 10, 2025 / Thijs van den Berg

In finance and signal processing, detecting trends or smoothing noisy data streams efficiently is crucial. A popular tool for this task is a linear regression applied to a sliding (rolling) window of data points. This approach can serve as a low-pass filter or a trend detector, removing short-term fluctuations while preserving longer-term trends. However, naive methods for sliding-window regression can be computationally expensive, especially as the window grows larger, since their complexity typically scales with window size.

Fig 5. The impact of number of samples on the variance of the confidence distribution.

Understanding the Uncertainty of Correlation Estimates

March 9, 2025 / Thijs van den Berg

Correlation is everywhere in finance. It’s the backbone of portfolio optimization, risk management, and models like the CAPM. The idea is simple: mix assets that don’t move in sync, and you can reduce risk without sacrificing too much return. But there’s a problem—correlation is usually taken at face value, even though it’s often some form of an estimate based on historical data. …and that estimate comes with uncertainty!

This matters because small errors in correlation can throw off portfolio models. If you overestimate diversification, your portfolio might be riskier than expected. If you underestimate it, you could miss out on returns. In models like the CAPM, where correlation helps determine expected returns, bad estimates can lead to bad decisions.

Despite this, some asset managers don’t give much thought to how unstable correlation estimates can be. In this post, we’ll dig into the uncertainty behind empirical correlation, and how to quantify it.

Can we measure president Bush’s heart rate when he was told about the 9/11 attack?

September 12, 2021 / Thijs van den Berg

This is a fun project me and my son did over the weekend.

I’ve always wondered what was going on in president Bush’s mind right after he was informed about the 9/11 attack.

Using a technique called Eulerian Video Magnification we were able to estimate his heart rate, and compare it right before- and after learning about the attack.

Extracting Interest Rate Bounds from Option Prices

January 19, 2021 / Thijs van den Berg

In this post we describe a nice algorithm for computing implied interest rates upper- and lower-bounds from European option quotes. These bounds tell you what the highest and lowest effective interest rates are that you can get by depositing or borrowing risk-free money through combinations of option trades. Knowing these bounds allows you to do two things:

1. Compare implied interest rate levels in the option markets with other interest rate markets. If they don’t align then you do a combination of option trades to capture the difference.

2. Check if the best borrowing rate is higher than the lowest deposit rate. If this is not the case, then this means there is a tradable arbitrage opportunity in the market: you can trader a combination of options that effectively boils down to borrowing money at a certain rate, and at the same time depositing that money at a higher rate.

Recovering Accurate Implied Dividend and Interest Rate Term-Structures from Option Prices

January 4, 2021 / Thijs van den Berg

In this post we discuss the algorithms we use to accurately recover implied dividend and interest rates from option markets.

Implied dividends and interest rates show up in a wide variety of applications:

to link future-, call-, and put-prices together in a consistent market view
de-noise market (closing) prices of options and futures and stabilize PnL’s of option books
give tighter true bid-ask spreads based on parity and arbitrage relationships
compute accurate implied volatility smiles and surfaces
provide predictive models and trading strategies with signals based on implied dividends, and implied interest rate information