Derivatives: Valuation and Risk Management

By David A. Dubofsky; Thomas W. Miller Jr. | Go to book overview
Save to active project


Current Topics in Risk Management

In this chapter, we discuss several currently important risk management topics: value at risk (VaR), credit derivatives, options on debt instruments, swaptions, and exotic options.


20.1.1 Background

One goal of active risk management is to reduce the variability of uncertain cash flows. As you have seen, however, risk management cannot eliminate this variability. Further, many examples that we have presented in this textbook have presented risk management vehicles dealing with a single risk, such as interest rate risk, foreign currency risk, commodity price risk, or stock market risk. However, the modern corporation could have hundreds, or thousands, of sources of uncertainty that are being hedged (or not being hedged).

Value at risk (VaR) is the name of a risk management concept by means of which senior management can be informed, via a single number, of the short-term price risk faced by the firm. The origin of “value at risk” stems from a request by J. P. Morgan's chairman, Dennis Weatherstone, for a simple report, to be made available to him every day, concerning the firm's risk exposure. Since then, VaR has rapidly become the financial industry's standard for measuring exposure to financial price risks. Today, few financial firms fail to make VaR part of their daily reporting to senior management.

Use of the VaR concept has become pervasive.1 The Bank for International Settlements (BIS), which is essentially the central bank of the world's major central banks, proposed in April 1995 that major banks use VaR to determine their capital adequacy requirements. These requirements became effective January 1, 1998. The U.S. Federal Reserve Bank and the International Swaps and Derivatives Association (ISDA) basically endorsed the BIS's recommendations about VaR. In December 1995, the U.S. Securities and Exchange Commission (SEC) proposed rules that would require corporations to disclose information concerning their use of derivatives. Firms would be directed to use one of three methods that would provide information about the risk exposure of their portfolios of financial assets and derivatives. One of the methods was VaR.2 In April 1996, eleven individuals from the institutional investment community formed the Risk Standards Working Group (1996) and charged themselves to “create a set of risk standards for institutional investment managers and institutional investors.” Risk Standard 12 states that money managers “should regularly measure relevant risks and quantify the key drivers of risk and return.” The standard proceeds to suggest VaR as one possible method for measurement of risk.3


Notes for this page

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
Loading One moment ...
Project items
Cite this page

Cited page

Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

Cited page

Bookmark this page
Derivatives: Valuation and Risk Management


Text size Smaller Larger
Search within

Search within this book

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

While we understand printed pages are helpful to our users, this limitation is necessary to help protect our publishers' copyrighted material and prevent its unlawful distribution. We are sorry for any inconvenience.
Full screen
/ 646

matching results for page

Cited passage

Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.

Are you sure you want to delete this highlight?