16:00
No good deals - no bad models
Abstract
The banking industry lost a trillion dollars during the global financial crisis. Some of these losses, if not most of them, were attributable to complex derivatives or securities being incorrectly priced and hedged. We introduce a new methodology which provides a better way of trying to hedge and mark-to-market complex derivatives and other illiquid securities which recognise the fundamental incompleteness of markets and the presence of model uncertainty. Our methodology combines elements of the No Good Deals methodology of Cochrane and Saa-Requejo with the Robustness methodology of Hansen and Sargent. We give some numerical examples for a range of both simple and complex problems encompassing not only financial derivatives but also “real options”occurring in commodity-related businesses.