CHAPTER 10
Model Risk and Financial
Derivatives
François-Serge Lhabitant
10.1 INTRODUCTION
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 var-
ious 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 techno-
logical 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.
The fundamental risks associated with derivatives (for example, credit,
market, operational and legal risks, among others) are no different from
those that many financial institutions and firms face in their traditional
businesses. However, the risks associated with derivatives can be far more
complex to assess and manage due to their dynamic nature, the asymmetry
of their payoffs and the implicit leverage of derivatives positions. Unlike
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