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http://ssrn.com/abstract=1115883
 
 

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The Usefulness of Inaccurate Models: The Emergence of Financial Risk Management


Yuval Millo


London School of Economics & Political Science (LSE) - Accounting Department

Donald MacKenzie


University of Edinburgh - School of Social and Political Science

March 1, 2008

Centre for Analysis of Risk and Regulation (CARR) Discussion Papers Series

Abstract:     
Is the growth of modern financial risk management a result of the accuracy and reliability of risk models? This paper argues that the remarkable success of today's financial risk management methods should be attributed primarily to their communicative and organizational usefulness and less to the accuracy of the results they produced. This paper traces the intertwined historical paths of financial risk management and financial derivatives markets. Spanning from the late 1960s to the early 1990s, the paper analyses the social, political and organizational factors that underpinned the exponential success of one of today's leading risk management methodologies, the applications based on the Black-Scholes-Merton options pricing model. Using primary documents and interviews, the paper shows how financial risk management became part of central market practices and gained reputation among the different organisational market participants (trading firms, the options clearinghouse and the securities regulator). Ultimately, the events in the aftermath of the market crash of October 1987 showed that the practical usefulness of financial risk management methods overshadowed the fact that when financial risk management was critically needed the risk model was inaccurate.

Number of Pages in PDF File: 41

Keywords: accounting, Black-Scholes, derivatives, options, risk management, social studies of finance (SSF)

JEL Classification: B25, G12, K22, N22

working papers series


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Date posted: April 3, 2008  

Suggested Citation

Millo, Yuval and MacKenzie, Donald, The Usefulness of Inaccurate Models: The Emergence of Financial Risk Management (March 1, 2008). Centre for Analysis of Risk and Regulation (CARR) Discussion Papers Series . Available at SSRN: http://ssrn.com/abstract=1115883 or http://dx.doi.org/10.2139/ssrn.1115883

Contact Information

Yuval Millo (Contact Author)
London School of Economics & Political Science (LSE) - Accounting Department ( email )
Houghton Street
London WC2A 2AE
United Kingdom
HOME PAGE: http://www.lse.ac.uk/collections/accounting/facultyAndStaff/profiles/Millo.htm
Donald MacKenzie
University of Edinburgh - School of Social and Political Science ( email )
Adam Ferguson Building
Edinburgh EH8 9LL
United Kingdom
+44 131 6508380 (Phone)
+44 131 6503989 (Fax)
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