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Most of the worst financial disasters since the 1970s have been caused by derivatives.
For instance in the early 1990s, Barings Bank lost $l bn after dubious trades with
interest rates futures, causing in turn the bankruptcy of this well-established bank. In 1998,
Long Term Capital Management lost $4 bn on somewhat similar products, resulting as
well in bankruptcy. More recently in January 2008, the French bank, Société Générale
realized a record loss of $7.1 bn after dubious trades on standard derivatives. Given the
severe losses incurred with these products, and their ever increasing volume of trade,
both practitioners and regulators have sought managerial techniques to reduce the
downside risk of derivative portfolios.
In practice, the common strategy to reduce and/or to control the downside risk
of derivatives is to liquidate a portfolio once a given level of loss is reached. This
practice is called benchmarking, and it is used for portfolios both of equities and derivatives
(see Pedersen (2001), Demirer and Lien (2003), and Basak et al. (2006) for more standard stock portfolios, see also Lakshman (2008) for other methods and their relative cost).
Leoni (2008) points out that benchmarking actually causes the reverse of what is expected,
that is, benchmarking actually aggravates the downside risk of derivative portfolios. There
is, thus a need to isolate factors, such as appropriate classes of assets, capable of reducing
the downside risk of derivative portfolios without involving drastic managerial
intervention, such as benchmarking. The current paper establishes, through a Monte-Carlo
simulation, how the mean-reversion of the underlyings dramatically affects the downside risk
of derivative portfolios. |
