Not only eggs will be broken

Volatility skew didn’t exist before the 1987 market crash. Before then, the assumptions of the Black-Scholes option pricing model were felt to be about right. Constant volatility, continuously tradeable instruments with no discontinuities in prices, independent returns from one period to the next.

Then the market crashed downwards exhibiting leptokurtic, negatively skewed returns and large jumps between prices. This posed a much higher risk to those providing protection against market crashes since dynamic hedging failed to match the losses.

As a result, deep out of the money put options are more expensive they “should be”. Their implied volatility is higher than for otherwise similar at the money put options.

Financial catastrophe = fundamental rethink about risk and massive long-term implications.

Enter the Euro debacle. Some estimates suggest a temporary 50% decline in Greek GDP in a disorderly exit from the Euro. To be clear, that is the only sort of of exit there can be.

All those countries naively thinking that a currency union without fiscal, social, cultural and political union is a good idea must surely be thinking about these newly highlighted risks? It’s complicated enough creating a currency union, but it’s a bloody mess when you have to unscramble it. Not only eggs will be broken.

Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.

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