4 ms·

The only true hedging is - you got an asset - you sell it forward. You are hedged. What passes for hedging and 'risk management' today in the financial industr

by 1gor 18y ago

The only true hedging is - you got an asset - you sell it forward. You are hedged. What passes for hedging and 'risk management' today in the financial industry is something different. You measure how one instrument has correlated with another instrument (or a basket) in the past build an offsetting portfolio based on these correlation matrices -- and voila! But your assumptions that those correlations between assets will stay the same in the future (including volatility etc) are baseless. As you see, it is also predicting the future. And it is wrong.

ctkrohn 18y ago
It's often impossible to sell an asset forward, especially an illiquid one. Suppose you are a trading desk that makes markets in corporate bonds. If a client comes to you and wants to sell a given company's bonds, chances are that you will not be able to immediately find a buyer. You will probably be forced to hold on to the bonds for a bit. Now you're exposed to interest rate and credit risks. What do you do? You can hedge some of the interest rate risk by paying on interest rate swaps, and you can hedge some of the credit risk by buying protection in the credit default swap market. But without some kind of model, it's going to be impossible to determine how to use these tools to hedge your risks. Your only other options are to guess, or to do nothing. If you are a large player in the markets, this is extremely dangerous. Certainly, it's foolish to assume that you are ever perfectly hedged. In this example, several things could go wrong: e.g. credit default swap traders could have a different view of a company's creditworthiness than corporate bond traders, forcing you to pay exorbitant prices for protection on the bonds. But this is a smaller risk than holding the bonds outright. In short: models can be helpful in risk management, as long as you are aware of the residual risks you are exposed to. Just don't allow them to make you complacent or overconfident.

by 1gor 18y ago

ctkrohn 18y ago

It's often impossible to sell an asset forward, especially an illiquid one. Suppose you are a trading desk that makes markets in corporate bonds. If a client comes to you and wants to sell a given company's bonds, chances are that you will not be able to immediately find a buyer. You will probably be forced to hold on to the bonds for a bit. Now you're exposed to interest rate and credit risks. What do you do? You can hedge some of the interest rate risk by paying on interest rate swaps, and you can hedge some of the credit risk by buying protection in the credit default swap market. But without some kind of model, it's going to be impossible to determine how to use these tools to hedge your risks. Your only other options are to guess, or to do nothing. If you are a large player in the markets, this is extremely dangerous. Certainly, it's foolish to assume that you are ever perfectly hedged. In this example, several things could go wrong: e.g. credit default swap traders could have a different view of a company's creditworthiness than corporate bond traders, forcing you to pay exorbitant prices for protection on the bonds. But this is a smaller risk than holding the bonds outright. In short: models can be helpful in risk management, as long as you are aware of the residual risks you are exposed to. Just don't allow them to make you complacent or overconfident.