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Wednesday, 16 May 2012

Derivatives valuations beyond human comprehension

The influence of large financial institutions over derivatives pricing has loosened the relationship between derivatives prices, their underlying assets, and their mathematical models, according to Chris Sheridan.  JP Morgan's recent loss suggests that theoretical pricing models of derivatives may no longer work properly.

Sheridan argues that JP Morgan's unexpected and large derivatives loss indicates that derivatives pricing behaviour is becoming less predictable, and therefore that traditional theoretical pricing models are now even less reliable than before.  Traditional linear mathematics and valuation formulae might no longer apply.  "Hyperconnectedness", and complex interdependencies between banks and portfolios, now dominate derivatives pricing.  This seems to be a reasonable assertion given that the total "theoretical" value of over the counter (OTC) derivatives exceeds US$700 trillion, which is far in excess of the value of the underlying assets from which they are derived.  (See "Financial risk continues to grow astronomically".)  Some reports suggest the value of derivatives would be nearer US$1,100 trillion if the Bank of International Settlements (BIS) had not altered their mathematical derivatives pricing models to reduce the official estimated value.  The fact that the official value decreased by approximately 30% confirms that the mathematical models can not provide a reliable indication of value.

The financial system, and derivatives portfolios, may have become so complex to be beyond human comprehension.  JP Morgan, who are one of the best managed banks on Wall Street, who are believed to be able to professionally manage financial risk, and who are deemed to be "too big to fail", appears to have been unable to comprehend their own "unicorn" hedge position which unexpectedly lost two billion dollars, so far.  Clearly, if JP Morgan had have comprehended their position they would not have unexpectedly incurred such a large loss so quickly.

This is cause for great concern.  If JP Morgan can't adequately understand their derivatives positions, who can?  Regulation becomes impossible.  It is not possible to manage a financial system which is beyond human comprehension.  Many large financial instituations' balance sheets are based on theoretically modelled asset valuations, which appear now to be even more unreliable.  Assets whose balance sheet values are based on theoretical models may not properly exist when when those assets are needed to prevent failure.

I thank Chris Sheridan for his article "Chaos, derivatives, and quantum physics", and Jim Sinclair for drawing my attention to it.

1 comment:

  1. MarketWatch reports that JP Morgan's loss is now 50% greater. That the blow-out comes within only a few days suggests that valuation methods, and JP Morgan's ability to control risk, can be unreliable. See MarketWatch's article at: