LECTURE_9_NOTES

LECTURE_9_NOTES - LECTURE 9 NOTES MODEL RISK AND LIQUIDITY...

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LECTURE 9 NOTES MODEL RISK AND LIQUIDITY RISK --Models for different kinds of products (Nonlinear, actively traded, structured) --Problems in model building --Liquidity Risk --Long-Term Capital Management (LTCM) Introduction Model Risk: Risk related to the models a financial institution uses to value different products. --Models are mostly necessary when pricing products that are relatively illiquid. --Since, when there’s an active market for a product, prices can be observed in the market. --There are two types of model risk: a) The model will give the wrong price at the time a product is traded. This can result in a price too high or too low. b) The other risk concerns hedging. If a wrong model is used, the hedges that are set up will be also wrong. Liquidity Risk (a deeper definition): Even if a FI’s theoretical price is in line with the market price, it cannot trade in the volume required at the price (since there are not enough buyers/sellers—and driving up prices, etc). --Models of finance describe the behavior of market variables. This behavior depends on the actions of human beings. Therefore, models are only approximations. (Behavioral finance) --The parameters of the models in finance are not constant. (The process of choosing model parameters is known as calibration.) Models for different kinds of products (Nonlinear, actively traded, structured) --Pricing linear products is straightforward. --Do not really need a model for actively traded products. (Use interpolation)
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--Models are used more significantly when hedging. --Within-model hedging: Risk of changes in variables that are assumed to be uncertain by the model. (price changes) --Outside-model hedging: Risk of changes in variables that are assumed to be constant (deterministic) by the model. (volatility) --Products that are tailored to the needs of clients are referred to as structured products. A
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LECTURE_9_NOTES - LECTURE 9 NOTES MODEL RISK AND LIQUIDITY...

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