Background
The growth and diversity made in financial engineering has led to highly creative and innovative strategies where new products and new structures are offered at very fast pace on the market. As most innovations are first proposed on over-the-counter (OTC) markets, they tend to rely on financial models, sometimes combining several models together. Financial models typically build on underlying assumptions and require calibration to a breadth of scenarios, business conditions and variations of the assumptions.
The shock wave which affected the credit and capital markets following the burst of the US sub-prime mortgage crisis in late 2007, tested most underlying assumptions and had sweeping effects on a number of models that would unlikely be calibrated for extreme market conditions, or tail risk. This led to an emergency call for transparency and assessments of exposure from the financial institutions’ clients, shareholders and managers, echoed by the regulators. In this process, it appears that market exposure and credit exposure intricately mix into a single notion of valuation risk.
Read more about this topic: Valuation Risk
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