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The business of derivatives

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2nd December 2009 | 12:36

THE BUSINESS OF DERIVATIVES

There was a time in the mid-nineties, more or less after Nick Leeson's ever-famous trickery, when derivatives blew up, causing major losses at many firms. Their market seemed to be at an end, but although more losses and collapses have followed, derivatives have flourished and new types of securities have been created. Modern synthetic securities are rather complex. They are created by combining a certain number of components which are often securities themselves. The world of finance is said to be a jungle, but we are not facing plain LIONs or TIGRs anymore: new securities are more similar to Dr Frankestein's monster. Do not be fooled by looks, though: such creatures are not evil and have no intention to rip our faces off. They are potentially dangerous but their risk can be controlled and limited by means of computational finance, often called rocket science because of its blend of complex mathematical formulae and modern computer technology. Computational finance is quite powerful: it calculates fair prices, predicts volatilities and assesses risks. Some products, in particular interest rate derivatives and repackaged bonds involving prepayment risk, are so complex that a bank might incur noticeable losses in case of mispricing - it really happened more than once, actually. Proprietary OTC trading desks and hedge funds are also heavily dependent on volatility-surface modelling and risk-assessment tools, and the number of activities which need computational models is growing at a fast pace, as derivatives are more and more often embedded into other assets. Moreover, real options further expand the field of application of derivatives pricing by including senior management decision planning. One of the latest confirmations of the need for risk control comes from the Basel Capital Accord, which obliges banks to adopt internal risk-assessment systems by 2004-2007 as increasing risk perception, in particular of credit risk, demands stricter capital adequacy rules. While Basel accord directions might suffice for needs the needs of conservative banks, institutions with a liking for financial innovation need more: bleeding-edge technology and skilled human resources are necessary in order to keep up with the challenge. Copyright 2002-2008. Best viewed with CSS and DHTML-compliant browsers.

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12/3/2009 1:02 AM