Reporter Fabrice Taylor authors an interesting article in the January 30, 2007 issue of Globe and Mail. It’s not a paper I regularly read though I may start. (This blog’s author happens to be in Toronto right now as a speaker about U.S. pension litigation trends, part of the Canadian Institute’s conference on Pension Law, Litigation and Governance).
Anyhow, I digress.
"The minefield of derivatives" points out a somewhat dramatic irony. How could a well-read UK risk publication have known that showcasing Societe Generale as the "Equity Derivatives House of the Year" in its January 2008 issue would later raise eyebrows? Taylor continues that derivatives are not inherently bad unless used by those "who don’t understand them or have the wrong incentives." Touche!
He urges readers not to scare in the presence of the very large numbers that characterize the global derivatives market. I concur. As I discuss in Risk Management for Pensions, Endowments and Foundations, notional principal amount is often a far cry from the economic exposure at stake. Another point which resonates is his comment that "Most derivative explosions happen when a trader thinks he understands the co-relationships between a basket of related derivatives and learns, painfully, that his computer models were wrong." Indeed.
Model risk is a story in bad need of being told again and again. This blog’s author has written a few articles on the subject. Drop a line if you’d like a copy. There is MUCH more to be said here, including what constitutes a good model and, by extension, when a model may be ill-suited or entirely inappropriate for a given situation.
Taylor concludes that greed drives many bad trades, frequently caught long after the damage has been done. Comparing last year’s Wall Street bonuses of $33 billion to $100 billion of reported credit write-downs, he adds "Shareholders lost that money; rest assured the bonuses won’t be repaid to them."
Interesting take from the land of the maple!