Stephen Figlewski
ABSTRACT
There has been much discussion of risks tied to trading in derivatives,
with some well-informed objective observers arguing that derivatives risks
are not significantly greater or different from those associated with traditional
financial instruments. Financial risks are often broken down into market
risk, credit risk, operational risk and legal risk. We review the standard
classification and observe that while derivatives are exposed to these
types of risk, they are manifested quite differently in derivatives than
in traditional securities. We then consider a 'new'
type of risk that is particularly important for derivatives: model
risk. Derivatives trading depends heavily on the use of theoretical valuation
models, but these are susceptible to error from incorrect assumptions about
the underlying asset price process, estimation error on volatility and
other inputs that must be forecasted, errors in implementing the theoretical
models, and differences between market prices and theoretical values. Empirical
evidence drawn from several important asset markets shows that model error
can be quite large and can be expected to lead to significant risk in derivatives
pricing and risk management
Subject: Investments, Derivatives, Banking (Theoretical, Empirical)
Figlewski: (212)-998-0712 sfiglews@stern.nyu.edu
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