Risk Management Lessons from the Global Financial Crisis for Derivative Exchanges

IIMA Working Paper No. 2009-02-06

26 Pages Posted: 10 Apr 2009

See all articles by Jayanth Rama Varma

Jayanth Rama Varma

Indian Institute of Management (IIM), Ahmedabad

Date Written: February 2009

Abstract

During the global financial turmoil of 2007 and 2008, no major derivative clearing house in the world encountered distress while many banks were pushed to the brink and beyond. An important reason for this is that derivative exchanges have avoided using value at risk, normal distributions and linear correlations. This is an important lesson.

The global financial crisis has also taught us that in risk management, robustness is more important than sophistication and that it is dangerous to use models that are over calibrated to short time series of market prices. The paper applies these lessons to the important exchange traded derivatives in India and recommends major changes to the current margining systems to improve their robustness.

It also discusses directions in which global best practices in exchange risk management could be improved to take advantage of recent advances in computing power and finance theory. The paper argues that risk management should evolve towards explicit models based on coherent risk measures (like expected shortfall), fat tailed distributions and non linear dependence structures (copulas).

Keywords: risk management, derivatives, fat tails, copulas, global financial crisis

Suggested Citation

Varma, Jayanth Rama, Risk Management Lessons from the Global Financial Crisis for Derivative Exchanges (February 2009). IIMA Working Paper No. 2009-02-06, Available at SSRN: https://ssrn.com/abstract=1376276 or http://dx.doi.org/10.2139/ssrn.1376276

Jayanth Rama Varma (Contact Author)

Indian Institute of Management (IIM), Ahmedabad ( email )

Vastrapur
Ahmedabad, Gujarat 380 015
India

HOME PAGE: http://www.iimahd.ernet.in/~jrvarma/

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