Problems related to modeling have accounted for about 20 percent of the $23.77 billion in derivatives losses that have occurred during the past decade, according to Capital Market Risk Advisors. Last year, however, model risk comprised nearly 40 percent of the $2.65 billion in money lost. The tally for 1997 included National Westminster Bank, with $123 million in losses, and Union Bank of Switzerland, with a $240-million hit.
A conference in February sponsored by Derivatives Strategy, an industry trade magazine, held a roundtable discussion called “First Kill All the Models.” Some of the participants questioned whether the most sophisticated mathematical models can match traders’ skill and gut intuition about market dynamics. “As models become more complicated, people will use them, and they’re dangerous in that regard, because they’ll use them in ways that are deleterious to their economic health,” said Stanley R. Jonas, who heads the derivatives trading department for Societé Generale/FIMAT in New York City. An unpublished study by Jens Carsten Jackwerth of the London Business School and Mark E. Rubinstein of the University of California at Berkeley has shown that traders’ own rules of thumb about inferring future stock index volatility did better than many of the major modeling methods.
One modeler at the session—Derman of Goldman Sachs—defended his craft. “To paraphrase Mao in the sixties: Let 1,000 models bloom,” he proclaimed. He compared models to gedanken (thought) experiments, which are unempirical but which help physicists contemplate the world more clearly: “Einstein would think about what it was like to sit on the edge of a wave moving at the speed of light and what he would see. And I think we’re doing something like that. We are sort of investigating imaginary worlds and trying to get some value out of them and see which one best approximates our own.” Derman acknowledged that every model is imperfect: “You need to think about how to account for the mismatch between models and the real world.”
Financial Hydrogen Bombs
The image of derivatives has been sullied by much publicized financial debacles, which include the bankruptcies of Barings Bank and Orange County, California, and huge losses by Procter & Gamble and Gibson Greetings. Investment banker Felix Rohatyn has been quoted as warning about the perils of twentysomething computer whizzes concocting “financial hydrogen bombs.” Some businesses and local governments have excluded derivatives from their portfolios altogether; fears have even emerged about a meltdown of the financial system.
The creators of these newfangled instruments place the losses in broader perspective. The notional, or face, value of all stocks, bonds, currencies and other assets on which options, futures, forwards and swap contracts are derived totaled $56 trillion in 1995, according to the Bank for International Settlements. The market value of the outstanding derivatives contracts themselves represents only a few percentage points of the overall figure but an amount that may still total a few trillion dollars. In contrast, known derivatives losses between 1987 and 1997 totaled only $23.8 billion. More mundane investments can also hurt investors. When interest rates shot up in 1994, the treasury bond markets lost $230 billion.
Derivatives make the news because, like an airplane crash, their losses can prove sudden and dramatic. The contracts can involve enormous leverage. A derivatives investor may put up only a fraction of the value of an underlying asset, such as a stock or a bond. A small percentage change in the value of the asset can produce a large percentage gain or loss in the value of the derivative.