UBS

[kr]

ok but the problem re: buried bombs comes down to quantifiability and inevitability. The quantifiability thing is pretty obvious but the side-effect is that you are well outside of a normal delta-hedging regime, and when deltas suddenly pick up, trading desk perception may be 'that is unusual and will go back to normal, we do nothing' - ok, it is unusual b/c that is why the contract was a tail contract in the first place, but conditional on that I would argue you can't make the second argument and think you know better about how things will play out. This happened to lots of people in subprime - by the time the delta was material, nearly every trader thought it was too expensive and remained unhedged. And this is where I do think VaR should have done a decent job - these boys were over limit and shouldn't have been granted an exception.



One might then say ok, if it cannot be managed safely, then it should not be permitted at all. But again I would say that arbitrage theory is never absolutely true in practice and there are always stub-ends of risk that are being run, and the natural trading approach is just to structure them out of the market so that they are not perceived to be a risk. It is not possible to book these things (i.e. funny doc risk and the like) so they are not managed and should get captured by other 'credit' type functions of the bank - i.e. run on a long-term self-insurance statistical basis.



So net-net I don't know what the answer is here - guess I am happy to accept the trader's option and live with it as the place where my own judgment meets my career track record. That there are people who are more reckless in applying the trader's option doesn't bother me either.

[Maggette]

"..One might then say ok, if it cannot be managed safely, then it should not be permitted at all. But again I would say that arbitrage theory is never absolutely true in practice and there are always stub-ends of risk that are being run, and the natural trading approach is just to structure them out of the market so that they are not perceived to be a risk.."

As an academic, I am prone to forget that......Insightful and on point as always..

Thanx kr