Risk management in exotic derivatives trading : Lessons from the recent past

Banks' product offering has become more and more sophisticated with the emergence of financial products tailored to the specific needs of a more complex pool of investors. This particularity has made them very popular among investors. By contrast to liquid, easily understandable "vanilla products" with a simple payoff, "exotic" or structured products have a complex risk profile and expected payoff. As a result, risk management for these structured products has proven to be costly, complex and not always perfect, namely due to their inherent dynamic characteristics inherited from their optionality features. In particular, banks' traders and investors in financial products with a digital optionality have experienced severe losses, either from pure downward pressure on asset prices or from difficulties to manage the inherent market risks properly.

This white paper presents a particular occurrence of this issue on the interest rate market, extends it to commodities, and details some risk management techniques that could have been used in order to avoid losses.