Introduction
Riccardo Rebonato is global head of market risk and global head of the Quantitative Research Team at the Royal Bank of Scotland (RBS). He also sits on the Investment Committee of RBS Asset Management. Dr Rebonato is a visiting lecturer at Oxford University and adjunct professor at Imperial College’s Tanaka Business School. He sits on the board of directors of ISDA (International Swaps and Derivatives Association) and the board of trustees for GARP (Global Association of Risk Professionals). He is an editor for several financial journals, and has written several books. He holds a doctorate in nuclear engineering and a PhD in condensed matter physics/science of materials from Stony Brook University, NY.
Models for Financial Risk Management
“All models are wrong, but some models are useful.” Anon
Quantitative models have come under intense scrutiny in the wake of the recent, and still unfolding, financial crisis. And justly so, as the way models have been used in these turbulent times has left a lot to be desired. Much of the criticism, however, has been misplaced, and, often, not even reasonably well-informed. The conspiracy theorists, for instance, who see in the blind acceptance by the “establishment” of the Normal distribution as the root of all evil, have, quite simply, missed the point. Those critics who have complained about “imperfect model assumptions” do not seem to appreciate that, if a model did not have some imperfect assumptions, it would not be a model at all, and that some very successful models in the hardest science of all (physics) often make outrageously unrealistic assumptions, yet can be just as outrageously successful. As I have been involved with models throughout all of my professional life, both as practitioner and academic, I intend to touch on the topic of models from an insider’s perspective. However, generalizing about “models in finance” would cause whatever conclusions or suggestions I might reach to be rather bland and generic. I therefore intend to focus on one particular set of applications: i.e., on the use of models for financial risk management.
One Model or Many Models?
I intend to argue that there exist a plurality of interpretative models of financial reality, and that each can be adopted or abandoned by market participants in an unpredictable fashion. If this view is correct, the search for the “true” model, for the unique “correct” mapping from information to prices, may be futile and some of the modeling risk-management efforts to date have been misguided. This has important consequences: the existence of competition among models and the resulting “fluctuations” between them can give rise to coordination among agents and feed back mechanisms into prices. This complex dynamic is beginning to be well-understood in some areas of finance and economics, but has not received sufficient attention in financial risk management. This, I believe, is dangerous, and has been one of the contributing factors to the current financial turmoil.
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