Introduction

In previous chapters we have introduced and analysed the standard market models for the valuation and risk management of synthetic CDOs. In this final chapter we consider the application of a relatively advanced simulation methodology for assessing the practical usefulness of a model: hedging simulation. For an investment bank trading and structuring complex financial derivatives on behalf of clients and for their own proprietary trading purposes, the quantification and management of risk is of paramount importance. In an ideal world the bank would be able to take positions in complex derivatives on behalf of clients and simultaneously enter into offsetting trades which would eliminate their risk. The spread that the bank earns as a commission for being the intermediary and structuring the deal then represents a risk-free profit. Life, unfortunately, is never that simple.

A significant risk that the investment banks run is the need to come up with prices for the structured instrument they construct for their clients. If the instrument is vanilla and liquidly traded there will probably be a market price that can be observed. It is more likely, however, that the instrument is bespoke and highly exotic to satisfy a particular client's risk/return requirement. To determine a price typically requires a sophisticated model. The uncertainty now is that the model fails to capture adequately all of the relevant risks that the product is sensitive to, leading to a price that could be arbitraged or a model that will not prove to be very effective at risk managing the exposure.