Daily Archives: March 8, 2011

Risk Management and Derivatives

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Slowly but surely, risk management systems are gaining in strength. We’ll time grows the systems have become widespread, settlement is normally now delivery versus payment, paper is disappearing and settlement times reducing or moving to real time, along with an increase in netting. All this reduces risk.

In derivatives, we are seeing fewer corporate, bank or be visible failures and the market seems to be much more mature. Growth continues to be strong, both in his published derivatives in a newer products such as credit repairs. There remain worries about the value at risk of statistical models of the lack of transparency in over-the-counter trading.

The first point, extreme conditions feedback a mockery of the so-called 99% copper levels. Prior to the Russian crisis, this would’ve suggested a widening of the spread on bonds generally as 200 basis points maximum. After the crisis, they widened to 900bp. Bankers Trust so that their value at risk model suggested that the value would only be exceeded on one day and 100. The problem here is that models do not take account of the possible collapse of the hedge. And Russia’s case, all forward rouble foreign-exchange deals were suspended. No model is likely to solve this problem, it’s perhaps part of the move to avoid global crisis.

Transparency is another problem. Long Term Capital Management had huge exposure to some 50 counterparties, but none of them knew of the overall exposure. The OTC market in derivatives is opaque, and some complex derivatives enable banks to overcome regulations on foreign exchange exposure. Foreign currency exposures in Mexico were much greater than was generally realized, partly for this reason. Japanese banks have used complex bond derivatives to take profits now, but push the associated losses out to 20+ years.
Under the heading of risk management comes the question of global crises and their prevention.

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