Risk Management Lessons from the Global Financial Crisis for Derivative Exchanges

INDIAN INSTITUTE OF MANAGEMENT
AHMEDABAD INDIA

Research and Publications

Risk Management Lessons from the Global Financial Crisis for Derivative Exchanges
Jayanth R. Varma
W.P. No.2009-02-06
February 2009

The main objective of the working paper series of the IIMA is to help faculty members, research staff and doctoral students to speedily share their research findings with professional colleagues and test their research findings at the pre-publication stage. IIMA is committed to maintain academic freedom. The opinion(s), view(s) and conclusion(s) expressed in the working paper are those of the authors and not that of IIMA.

INDIAN INSTITUTE OF MANAGEMENT
AHMEDABAD-380 015
INDIA

IIMA

INDIA

Research and Publications

Risk Management Lessons from the Global Financial Crisis for Derivative Exchanges
Jayanth R. Varma *

Abstract
During the global financial turmoil of 2007 and 2008, no major derivative clearing house in the world encountered distress while many banks were pushed to the brink and beyond.
An important reason for this is that derivative exchanges have avoided using value at risk, normal distributions and linear correlations. This is an important lesson. The global financial crisis has also taught us that in risk management, robustness is more important than sophistication and that it is dangerous to use models that are over calibrated to short time series of market prices. The paper applies these lessons to the important exchange traded derivatives in India and recommends major changes to the current margining systems to improve their robustness. It also discusses directions in which global best practices in exchange risk management could be improved to take advantage of recent advances in computing power and finance theory. The paper argues that risk management should evolve towards explicit models based on coherent risk measures (like expected shortfall), fat tailed distributions and non linear dependence

References: Artzner et al (1999), “Coherent Measures of Risk”, Mathematical Finance, 9(3), 203228 Basel Committee on Banking Supervision (BCBS) (1996) “Amendment to the capital Basel Committee on Banking Supervision (BCBS) (2001) “Consultative Document: The Internal Ratings-Based Approach Basel Committee on Banking Supervision (BCBS) (2004) “International Convergence of Capital Measurement and Capital Standards: A Revised Framework”, Bank for Basel Committee on Banking Supervision (BCBS) (2009), “Guidelines for computing capital for incremental risk in the trading book”, Bank for International Settlements. Bhalla, Surjit S (2008) “The ultimate crisis machine – Sebi’s risk management”, Business Standard, January 26, 2008. Fournie, E; J Lasry and PL Lions (1996) “Some nonlinear methods to study far-fromthe-money contingent claims” in Rogers, L. C. G. and Denis Talay (ed) Numerical Methods in Finance, Cambridge University Press. Gupta LC (Chairman) (1998), “Report of the Committee on Derivatives”, Securities and Exchange Board of India. Haldane , Andrew G (2009), “Why banks failed the stress test”, Bank of England, www.bankofengland.co.uk/publications/speeches/2009/speech374.pdf JP Morgan/Reuters (1996) “RiskMetrics Technical Document” Kuritzkes, A Lee, S W and Hansen, B E (1994) “Asymptotic theory for the GARCH (1,1) quasimaximum likelihood estimator”, Econometric Theory, 10, 29-52. Lothian, J. R. and Mark P. Taylor (1996), “Real exchange rate behaviour: The recent float from the perspective of the past two centuries”, Journal of Political Economy, Reserve Bank of India and Securities and Exchange Board of India (2008) “Report of the RBI-SEBI standing technical committee on exchange traded currency futures” Varma, J R (1999) “Rupee-Dollar Option Pricing and Risk Measurement: Jump Processes, Changing Volatility and Kurtosis Shifts”, Journal of Foreign Exchange and International Finance, 1391), 11-33 Varma, J R (Chairman) (2002) “SEBI Advisory Committee on Derivatives: Report on W.P. No. 2009-02-06 Page No Research and Publications Varma, J R (2007) “Risk Management at Indian Exchanges: Going Beyond Value at Risk”, Seminar at Indian Council for Research on International Economic Relations , January 9, 2007. Varma, J R (2008) “Note on revising the margining of stock index futures in India”, mimeo, August 2008, revised September 2008. W.P. No. 2009-02-06 Page No