Global Valuation and Dynamic Risk Management

Claudio Albanese, Guillaume Gimonet and Steve White

This article was first published as a chapter in Managing Illiquid Assets: Perspectives and Challenges, by Risk Books.

Some instruments, such as interest rate swaps and variance swaps, admit low-risk, fairly robust replication strategies that do not rely on probabilistic models. As a consequence, these instruments are traded with confidence and they are among the most liquid pillars of financial markets. Conversely, instruments which cannot be easily replicated are not liquid and require model-based valuation.

To arrive at a consensus around valuations of illiquid instruments, the finance industry has structured itself around standards. Valuation methodologies have historically followed cycles whereby innovations were promoted, disseminated and finally established into industry-wide standards. Rating methodologies developed into standards for the sake of maintaining consistency. Risk management methodologies developed significantly in the 1990s after the introduction of value-at-risk (VaR) measures (JP Morgan-Reuters 1996) and mark-to-market and mark-to-model accounting. Capital adequacy directives subsequently encoded the industry practice into a regulatory framework.

S