Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Risk Management for Derivative Exchanges

I wrote a chapter on risk management lessons from the global financial crisis for derivative exchanges for a book edited by Robert W. Kolb on Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future.

Kolb Book Front Cover

During the global financial crisis, no major derivative clearinghouse in the world encountered distress, while many banks were pushed to the brink and beyond. This was despite the exchanges having to deal with more volatile assets—equities are about twice as volatile as real estate, and natural gas is about 10 times more volatile than real estate. Clearly, risk management at the world’s leading exchanges proved to be superior to that of the banks. The global financial crisis has shown that the quality of risk management models does matter.

Three important lessons have emerged from this experience:

  1. The quality of risk management models can be measured along two independent dimensions: crudeness versus sophistication and fragility versus robustness. The crisis of 2007-2009 has shown that of these two dimensions, the second dimension (robustness) is far more important than the first dimension (sophistication).
  2. An apparent structural change in the economy and the financial markets may only be a temporary change in the volatility regime. Risk models that ignore this can be disastrous.
  3. Risk models of the 1990s, based on normal distributions, linear correlations, and value at risk, are obsolete not only in theory but also in practice.

Most of the chapter paper deals with these lessons from the crisis of 2007-2009. In the final section, the paper argues that as derivative exchanges prepare to trade and clear ever more complex products, it is important that they refine and develop their risk models even further so that they can survive the next crisis.

The chapter is based largely on a paper that I wrote in February 2009.

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