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Professional Financial Risk Models

Written by A Forex View From Afar on Thursday, April 03, 2008

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Since the beginning of the sub-prime mess, that marked the current meltdown of the financial system, one of the things that carried a lot of the blame was the Financial Risk models.
In the big picture, there are two types of risk-models: The Arbitrage Pricing model and the Black-Scholes Pricing model.

The Black-Scholes model is used in options, an insurance or hedge on an underlying security/asset that is being held, normally Equity/Stock based. Currency options are not (yet) as well used by retail traders as the spot market, so we are going to focus on the Arbitrage model

Arbitrage Pricing is one of the blueprints that created risk models. It was first develop in the 70s by Stephen Ross and it soon took the financial world by storm. Arbitrage Pricing is, in its most simple form, a math formula, where external shocks (such as macroeconomic data) take the form of coefficients. Using this formula, it is possible to determine a future expected price.

At a future date, if the price of the asset is not in line with the calculated price by the arbitrage theory someone could use this opportunity to do an arbitrage trade between the risk-asset and a synthetic range of assets (an index).

A good example would be if the risk-asset is overpriced; then go short the risk-asset, and long the index, until the risk-asset's price is inline with value calculated by the Arbitrage Pricing.
In the forex market such arbitrage systems could be made between the Eur/Usd pair, and the dollar index; The Euro makes up 60% of the dollar index. As for the external shock, we could use the macro-economical and market data such as inflation, GDP, Fed Funds Futures and Consumer Sentiment. Pretty much they gauge Trade Desk expectations and they would qualify as good coefficients in the math quote. We could say almost every pair has its own possibility, and we know the Commodity link between them all as well.

It's very important to note that these types of risk models created two very important financial turn-offs, first in 1998 with the LTCM bankruptcy, and now with the current credit crises. Even if they sound risk free in theory, as proved in practice, most of the time the risk-free part turns out into risk-horror.

If someone would ask me, I'll stick for now to my "risk model", not more then 2% per trade. The best, and the only flawless risk model that we have.

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