Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Risk Management Lessons for Derivative Exchanges

A few days ago, I finished a paper on Risk
Management Lessons from the Global Financial Crisis for Derivative
Exchanges
. The abstract of the paper says:

During the global financial turmoil of 2007 and 2008, no major
derivative clearing house in the world encountered distress while many
banks were pushed to the brink and beyond. An important reason for
this is that derivative exchanges have avoided using value at risk,
normal distributions and linear correlations. This is an important
lesson. The global financial crisis has also taught us that in risk
management, robustness is more important than sophistication and that
it is dangerous to use models that are over calibrated to short time
series of market prices. The paper applies these lessons to the
important exchange traded derivatives in India and recommends major
changes to the current margining systems to improve their
robustness. It also discusses directions in which global best
practices in exchange risk management could be improved to take
advantage of recent advances in computing power and finance
theory. The paper argues that risk management should evolve towards
explicit models based on coherent risk measures (like expected
shortfall), fat tailed distributions and non linear dependence
structures (copulas).

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One response to “Risk Management Lessons for Derivative Exchanges

  1. Mon March 4, 2009 at 6:04 pm

    Isn’t this whole financial crisis a result of over dependence on quantitative risk measures? CDO pricing is done using Gaussian copulas and look what happened. My point is that we should be seriously questioning whether measures like risk and correlation can really be quantified/modeled when it comes to securities. I do not intend to say that I have a better solution but it should not be a reason to accept something without realizing the essence of it.

    As I see it, discipline of risk management, like macro-econ, has been exposed bare. Till we find a better solution we should very explicitly acknowledge increasing role of subjectivity to complement mathematical models.

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