Many financial disasters have been caused by derivatives, despite the recent introduction of those products in the 70s. The resounding case of Barings Bank in the early 90s, with a loss of $1bn after dubious trades on interest rates futures that led to the bankruptcy of this century-old bank, was the first warning of the danger of derivatives trading. A long list of similar disasters soon followed, and we just give a few of them. In 1998, Long Term Capital Management lost $4bn on somewhat similar products, resulting as well in bankruptcy of this business with the involvement of well-established personalities.
The record to date is held by the French bank Société Générale, which realized in 2008 a staggering loss of $7.1bn after dubious trades on standard derivatives. To fix ideas, this loss corresponds to the overall real GDP of Nicaragua in 2008 that got vaporized in a matter of months. Given the potential severity of losses associated with those products, and their always increasing volume of trades, both practitioners and regulators have sought managerial techniques to reduce the downside risk of derivatives portfolios.
We first describe the managerial methods currently used in practice and their relative cost, and we then show that the most common methods actually aggravate this downside risk. We then argue that selecting appropriate underlyings satisfying some specific statistical and easily identifiable properties is a natural way to significantly reduce the downside risk without involving costly managerial interventions.
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Managerial Methods to Control the Downside Risk of Derivatives
