October 2, 2007
Derivatives and Banks
There is a worldwide explosion in the use of off-exchange (OTC) derivatives by asset managers (such as university endowment offices) and pension funds. This means, of course, that there is a similar explosion in the writing of such derivatives by counter parties, investment banks. As numbers and variety of the complex instruments proliferate there are two problems -- a short term back office processing problem and longer term valuation problems. Both problems increase the risk of mistakes and any major trading mistake, given the inherent leverage of these instruments, can have huge consequences. It is likely that we will see, with some increasing frequency, some spectacular losses as investment managers or bank agents miscalculate risk and valuation on some of these exotic instruments. The quality of internal controls over investment decisions make by fund traders will be sorely tested and some will be shown to have been wanting.
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