Traders Should Develop New Derivative Pricing Models

June 21, 2012 by  Filed under: Management 

The recession has caused much disjunction to the derivatives model. Not only have new regulations limited the amounts of derivatives that companies can carry, in accordance with the Basel legislation which requires a company to maintain a certain level of capital that will be phased in over a period of time, but firms have made conscious decisions to limit the amount of derivatives that a company should carry for several reasons. For one, financial firms have determined that it is not appropriate to carry derivatives to the point where they are putting their firms at risk of bankruptcy. This is particularly true when a firm holds many derivative positions. What they believe may result in a successful hedge of their company, may in fact, not provide much of a hedge at all. As a result, the increasing complexity of these positions have led firms to further limit the number of derivatives that they enter into.

Public perception has also limited the number of derivative transactions that a company gets into. This is particularly true for financial firms, particularly those that are deemed to be “too big to fail”. The public resents the government bailout from a few years ago and does not want to see these companies put themselves at risk for having to cover these losses. The public is not looking for private profits and public losses, as have occurred in the past with certain financial firms. Derivatives pricing therefore has taken on a new area of importance to ensure that firms are compensated for the risks that they take.

All of this has led to a new disjoint of derivatives pricing that traders must adapt to. Traders Should Develop New Derivative Pricing Models to meet these new financial realities. Gone are the days where firms could hedge many different derivative transactions. Now derivatives must be priced in a way to reimburse these financial firms for the risks that they are taking, or firms must take positions that are noticeably less risky or further out of the money.

As many financial firms emulate each others strategies, they have to, in effect, purchase the same securities. The demand for these securities has led to a raising of the price of the desirable positions, as the demand has increased for them. This has led these financial firms to have to adjust their way of doing business and pricing these derivatives. Derivative pricing has therefore taken on a new level of importance in these financial firms and much analysis needs to be done before any significant derivatives are entered into.

Derivatives pricing has become more complex in the last year; learn about challenges and opportunities on our web site.

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