Difficulties in the Pricing of Risks in a Fast-Moving Financial Landscape (A Methodological Perspective)
10 Pages Posted: 24 Sep 2009
Date Written: September 17, 2009
Abstract
Before the onset of the ongoing credit crisis I concluded that the available evidence supported the notion that financial markets were (significantly) underpricing risk . It will be argued in this paper that inherent (or structural) difficulties in the pricing of all sorts of risks is an important feature of the fast-moving financial landscape. To that end, I will introduce a methodological framework for assessing the pricing of uncertainty and risks. It will be shown that there are four key reasons why markets are structurally underpricing risks. Firstly, the complexity and opaqueness of a fast-moving financial landscape strain the abilities of market participants to price risks correctly. Secondly, it is a fact of life that financial markets are liable to overshoot. Thirdly, the reasons given by analysts for rationalizing extreme low risk premia in financial markets are far from adequate, thereby strengthening the case that risks are being systematically underpriced. Finally, the sources of much fundamental uncertainty in society are ill-defined, making it very hard or impossible to calculate the associated odds (risks). More specifically, I will distinguish five key features of the new financial landscape that had, and will continue to have, important influences on mispricing.
JEL Classification: G01, G12, G14, G2
Suggested Citation: Suggested Citation
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