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Unformatted text preview: 9 C A N A D I A N I N V E ST M E N T R E V I E W | W I N T E R 2 0 0 9 E x p e n s i v e EDUCATION How last years financial crisis taught us everything we needed to know about risk management. BY ROBERT A. JARROW T h e recent credit crisis offers an opportunity to reflect upon the success and failure of existing risk management tools, putting the spotlight on two in particular: traded derivatives to hedge credit risk and risk management models to quantify credit risk. Did these risk management tools fail? The financial press has blamed these new fangled derivativesespecially those on subprime mortgages and the risk management models as the cause of the crisis. Warren Buffett admonished models and quantitative researchers in a Wall Street Journal report, warning, All I can say is, beware of geeks bearing formulas. ( WSJ November 3, 2008.) And in testimony to Congress days before, Alan Greenspan stated, Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment. Perhaps. But before we can form a judgment, we need to dispel three myths that appear repeatedly in the financial press, claiming that: (1) derivatives are new; (2) derivatives are bad, and (3) using risk models is bad. Contrary to common belief, the first myth is false. Derivatives are not new. Derivatives have been trading for thousands of years. Forward contracts existed in cuneiform script on clay tablets in Mesopotamia, 2000 B.C. Forward trading in commodities such as grain, salt, wool and herring appeared in ancient medieval fairs between the 5th and 15th centuries, with Venice the centre of such trading in the 1400s. The modern era of derivatives really began in 1600s Amsterdam with the trading of options and futures. Even then, derivatives were blamed for high commodity prices and enabling manipulation. Regulatory bans on short sales were occasionally imposed and removed, with defaults on financial contracts commonly litigated. Does this sound familiar? But, if derivatives are not new, why have they existed for so long? The answer to this question brings us to our second myth that derivatives are bad. DEFENDING DERIVATIVES Derivatives are not bad. The reason derivatives have existed for so long and why they are so pervasive today is that they improve individual welfare by enabling the hedging of financial risks. To understand why this is true, one just needs to recognize that financial derivatives are really types of insurance contracts. To understand this perspective, consider the simplest derivative security, a put option on a stock. For discussion, let the stock be currently trading for $120....
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This note was uploaded on 10/31/2010 for the course NBA 5550 at Cornell University (Engineering School).