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Non-Tech : Derivatives: Darth Vader's Revenge -- Ignore unavailable to you. Want to Upgrade?

To: Merritt who wrote (974)	10/26/1999 11:40:00 AM
From: Henry Volquardsen	Read Replies (1) \| Respond to of 2794

Merritt, aren't the computational models used to determine the risk/premium predicated on averages - averages that don't necessarily account for dramatic events and swings? actually the models tend to be much more complex than averages. they are much more oriented towards the odds of an event occuring. But more to the point of your question, yes the original models did not account very well for dramatic events and swings. They were much more oriented towards managing for the average daily movement. But the market has been very aware of this shortfall for a very long time. As a result the market has been putting a lot of effort into developing various tools for measuring this type of risk. Two of the tools that are being widely used is value at risk and stress testing. These are done on a portfolio basis and gives you a much better picture of the risk for a large move. So the old models continue to be used to price inidividual deals while the new tools are used to manage on a portfolio basis. With the trillions of dollars of potential risk exposure (in reality probably only a few hundred billion<g>) in the event of a major, and protracted, move in interest rates, or market indexes, and/or forex, isn't it a possibility that these wonderful vehicles could cause a smash-up of our entire economic system, or are there collars in place to limit loss? Anything is always possible :). But the point is that the risk management system continues to evolve. When I got in the business almost no one senior to me or my peers knew what we were up to. Now people like us have advanced into positions of senior management and have an understanding of the risks. We have built much more robust managemenet systems. In addition the regulators are also much better informed on the topic. As a result I believe the risks, even though much more complex, are much better understood and manageable than they were twenty years ago. Can a mistake happen? Of course. I just think it less likely. And the management models are not static. As markets move the risks can be hedged. Didn't AG bail out LTCM just because of such fears? AG didn't bail out LTCM, the banks did. The Fed identified the risk and got the banks to sit down and talk to each other, a very appropriate role in my opinion. In addition I still do not think of LTCM as essentially a derivative problem. Derivatives, in my opinion, were incidental. It was essentially a leverage problem. The banks had extended way to much credit. This is very much an issue the Fed should be involved in monitoring. Henry