Risk Management Models: Construction, Testing, Usage
17 Pages Posted: 21 Nov 2010 Last revised: 16 Mar 2011
Date Written: March 15, 2011
Financial risk management models were often used wrongly prior to the 2007 credit crisis, and they are still being used wrongly today. This misuse contributed to the crisis. We show that there are two common misuses of derivative pricing models associated with calibration and hedging “the greeks.” The purpose of this paper is to clarify these misuses and explain how to properly use risk management models. In particular, we show that: (i) the implied default probabilities from structural credit risk models and the default probabilities obtained from credit risk copula models are mispecified, and (ii) vega hedging is a nonsensical procedure.
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