Model Risk and Financial Derivatives

Since the introduction of option trading in Chicago in 1973, derivatives have shaped the evolution of capital markets by allowing efficient risk unbundling and transfer. Financial intermediaries immediately recognized that derivatives were the perfect tool to customize state-contingent payoffs for both speculators and hedgers alike. Consequently, the volume and various types of derivative contracts traded on organized exchanges as well as in over the counter markets have grown steadily. The catalysts of this success were the development of financial theory and sophisticated pricing mathematical models, the availability of real-time information, the technological innovation (in particular increasingly powerful computers) as well as the move from open-outcry trading to electronic trading. Today, we have reached the point where derivatives have become an essential feature of practically any financial contract. They have changed the way companies and individuals make investments, raise capital, and even measure, manage and understand risk.