Derivatives: Used & Abused
FT reports that “fewer than half of global financial institutions account sufficiently for complex financial and commodity exposures in assessing the riskiness of their holdings”.
The Deloitte survey showed that only 41% of executives reported using value-at-risk (VaR) models to cover credit derivatives, with fewer than half of them using VaR analysis extensively. VaR is a measure of the probable losses on a portfolio if historically big - but not extreme - market moves occur.
Fewer than half of respondents regularly used “stress-testing”, a technique recommended in reports on systemic risk. Stress-testing aims to estimate losses in a severe stock market crash.
Also, the latest weekly report by Parag Parikh of PPFAS raises concerns about how derivatives are being touted in the Indian markets, to institutional investors no less:
These corporates felt that many a time, banks were thrusting unwanted products on them, either by invoking their fear (of huge potential losses inherent in unhedged positions) or greed (of making huge amounts of money by employing leverage). The basic grouse of corporates was that banks do not adequately highlight the risks involved in such products and only speak about the benefits. Also, the bank’s compensation structure for peddling such products was not outlined clearly enough.
There’s no dearth of essays that talk about apocalyptic outcomes due to derivatives; but for a more mathematical take on why VaR may be a bad idea, check Taleb’s site.
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