Current Issue
Contents - August/September 2008, Issue 43
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FEATURES:
Cover Story: Model Risk
Models play an important role in financial risk management. But are we guilty of misusing them, and has an overreliance on models contributed to the credit meltdown? Dr. Sebastian Fritz and Jörg Erlebach give examples of model breakdowns in different industries, explain why models often do not function properly when markets take unanticipated turns and offer advice on how to use models properly.
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Risk Analysis
Do asset correlations increase during periods of market stress? What exactly is the relationship between economic downturn conditions and correlations? And what impact does this have on capital requirements? Dr. Marco Folpmers and Peter de Rijke examine the market stress/correlations relationship and offer an empirical demonstration of their findings.
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Hedging
Based on the twin assumptions of continuous asset price movements and complete markets, dynamic replication is invoked to generate the correct value for a derivative security. However, dynamic replication requires continuous trading — something that is largely unattainable in practice. Hedging, therefore, occurs discretely, which, when combined with the fact that traders tend to hedge their net positions and not individual trades, means that hedging errors occur and persist. Such errors tend to be magnified in periods of significant market discontinuity and can be further exacerbated by shortages of liquidity, such as has been witnessed during the current credit crunch. These largely well-understood failures of dynamic hedging, particularly in periods of severe market turbulence, have highlighted the need for an alternative approach. Professor Mark Salmon and Dr. Stephen Weston examine the problems with existing dynamic hedging approaches. They then suggest how preliminary results of their recent research point to an alternative that uses techniques borrowed from the engineering world of optimal control. Their initial finding is that an optimal control approach is always far more expensive than dynamic hedging, but, subject to further work, it may just provide a solution to the problem of hedging in highly volatile environments.
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DEPARTMENTS:
Editor's Letter
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Academic Research
The benefits of diversification, the best techniques for determining credit default swap spreads and the reasons behind the global credit crisis are among the interesting topics discussed in recent research papers. Til Schuermann and Peter Tufano offer a quick summary of these papers, and author-supplied extended abstracts provide further enlightenment.
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Risk Tutorial
Loss distribution for homogeneous collateralized debt obligations (CDOs) can be estimated using a one-factor copula model. Though numerous academians and practitioners have discussed the theoretical component of this model, beginners still find it difficult to implement. Prashant Goyal offers a step-by-step approach for calculating loss distribution using MS Excel visual basic for applications (VBA). This approach, once understood, can also be used as a basic framework to price CDO tranches and nth-to-default credit default swaps.
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Operational Risk
Operational risk management has evolved to the point where it has become a priority for many financial services firms. This is particularly evident in Islamic banking, but operational risk practitioners in that business may face more obstacles than their counterparties in conventional banking. Horst Simon investigates.
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Book Review
Steve Xia critiques Tom Miller’s Introduction to Option-Adjusted Spread Analysis.
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*The opinions expressed by GRR contributors are their own, and do not necessarily reflect the views of GARP or its editorial board.
