Emanuel Derman, managing director, firm-wide risk at Goldman Sachs, originally wrote this primer on how risk managers help price derivatives for his firm’s traders. We felt it deserved a wider audience.
Trading desks in many product areas at investment banks often have substantial positions in long-term or exotic over-the-counter derivative securities, custom-tailored to satisfy the risk preferences of their customers. The idiosyncratic nature of these securities makes them relatively illiquid.
As a consequence, these positions are marked and hedged using sophisticated and complex financial models, implemented as software and then embedded in front-office risk management systems. These models derive prices from market parameters (volatilities, correlations, prepayment rates or default probabilities, for example) that are forward-looking and should ideally be implied from the market prices of traded securities.
Because of their illiquidity, many of these positions will be held for years. Yet their daily values affect the short-term profit and loss of the banks that trade them, and also inevitably influence the careers and compensations of the traders and salespeople who structure, trade, hedge and market them.