This article starts with pointing to a document that is the first and introductory chapter of the book BICs 4 Derivatives Volume I: Theory, published in October 2005. It makes the case for the need for BICs (Basis Instruments Contracts) as new paradigm for derivatives pricing, hedging and risk management.
It is partially continued here with a discussion which uses an accidental choice of words in recent events “Greek”, to emphasize the limitations of parametric sensitivities based derivatives risk management
The disclosure in the winter of 2010 of the Greek Government’s fateful foray into derivatives as an illusory tool to eliminate the appearance of government deficits at little cost pushed the country to the brink of insolvency, to the point of raising concerns about the viability of the European Union and undermining the value of the Euro, thereby triggering the 2010 European Sovereign Sovereign Debt Crisis. It is one more instance of how derivatives instruments handed into unsophisticated or complacent hands can turn into financial instruments of mass destruction.
By strange coincidence of words, in the world of derivatives quantitative risk management, Derivatives’ ‘Greeks” means something altogether different; Derivatives’ ‘Greeks’ stands for the sensitivity of the price of a derivatives contract to the various parameters that underlie the parametric assumptions used to derive a price. For example, for a standard call or put option derivatives contract, on a given underlying such as a corporate stock, under the standard Black Scholes parametric assumptions, the sensitivity to the stock price is called Delta(∆, the sensitivity of the Delta to the stock price is called Gamma (Γ ), the sensitivity of the option price to the volatility of the stock price is called Vega (ν), etc. These are all Greek symbols, hence the name Derivatives’ ‘Greeks’.
Quite strangely too, it turns out that in many of the recent large scale financial institutions disasters, reliance on derivatives Greeks helped in many instances fatally hide the scope of risks taken. Derivatives risk management with ‘Greeks’ works by creating a portfolio that eliminates or minimizes Greeks values, unless one seeks to purposely create risk exposure for speculative purposes.
However, at the core of such a practice lies the fallacy that the parametric assumptions used to compute the derivatives price are a robustly accurate representation of the reality of risks faced. For the most part, it works under normal market circumstances. But when it does not work is when most needed, that is when the market stops being normal and liquidity dries up, when there is no more semblance of continuous time trading.
By and large the most sophisticated Derivatives risk managers still think of derivatives risk in terms of handling the multiple dimensions of such Greeks. After a little experience a seasoned practitioner would be aware that it is not only first or second order sensitivities that one should seek to control, but even third or fourth order sensitivities. But the fact is, this is a treacherous path altogether. The order of sensitivities that one must pay attention to is infinite and, most importantly, the parametric assumptions are inaccurate and tend to actually exacerbate the problem at times of market stress. This is the story of portfolio insurance strategies in the 1987 crisis, continuing up to the AIG bailout and the Lehman failure.
Both conceptually and practically, BICs (basis instrument contracts), a set of hedging contracts and a new risk management and probabilistic conceptual framework that I developed in 2001 are precisely meant to help against this type of dangerous model mis-specification problem. Let’s say we are in a real life multi-period trading environment at the end of which is a payout that’s a function of the realized values of underlyings observed in the time frame. A BIC is a unit representative of a class of contracts that together as a set compose or replicate the payout—no matter how unusual, complex, or illiquid—in a static manner.
Such contracts are model independent and provide accurately estimated and actionable pricing probabilities backed by tangible hedging contracts. They help simplify the complexity of the most arcane derivatives contracts by helping break them into the familiar.
Getting to a familiar appreciation of BICs and the substantial benefits they provide may require a rewiring of the mathematics of risk learned and practiced over many decades. Much has been written about the regulatory and institutional failures in the run-up to the crisis. Many of the arguments are true, but fundamentally, most of these analysis frame the issue in a familiar pattern of common understanding where decision makers are mostly attorneys or legal minds that fails to appreciate the paramount importance of a mathematical theory of risk and uncertainty that was built not as a handy transplant of physicists purposes, as is currently is the case, but by the combination of an a priori deep understanding of mathematics and finance and the translation of that understanding in a purposeful operational and practical tool for managing risk.
When such a well designed foundational framework is in place, a lot trivially soon falls in place. It may take a while to happen, but ultimately, it is a critical element of what is most needed to prevent the accelerated repeat of the small and not so small financial crisis witnessed in recent decades.
As George Orwell said best “But if thought corrupts language, language can also corrupt thought.”.The current Derivatives’ Greeks language of Derivatives Risk Management corrupts thoughts.
For more see:
BICs 4 Derivatives Volume I : Theory
A bit of related erudite humor at http://www.nytimes.com/2010/05/23/opinion/23buckley.html