Derivatives Risks, Old and New

There has been much discussion of risks tied to trading in derivatives, with some well-informed objective observers arguing that derivatives risks are not significantly greater or different from those associated with traditional financial instruments. Financial risks are often broken down into market risk, credit risk, operational risk and legal risk. We review the standard classification and observe that while derivatives are exposed to these types of risk, they are manifested quite differently in derivatives than in traditional securities. We then consider a 'new' type of risk that is particularly important for derivatives: model risk. Derivatives trading depends heavily on the use of theoretical valuation models, but these are susceptible to error from incorrect assumptions about the underlying asset price process, estimation error on volatility and other inputs that must be forecasted, errors in implementing the theoretical models, and differences between market prices and theoretical values. Empirical evidence drawn from several important asset markets shows that model error can be quite large and can be expected to lead to significant risk in derivatives pricing and risk management