Abstract - Observations on Risk Propagation and the Dynamics of Macro Financial Crises: A Derivative Perspective

As indicated by the title, I will apply modern financial derivatives methodology to analyze the dynamics of macro financial crisis and to discuss various common elements in crises. My remarks are divided into three parts:
1) Demonstrate how basic risk management tools can provide structural insights and prediction into how risks propagate across sectors of an economy by a kind of credit contagion which can rapidly increase risk of the system and lead to financial crisis. We shall use this analysis to discuss some ongoing research on the current crisis on how the mortgage finance market in the US may have become particularly vulnerable as a consequence of the coincidence of the institutionalization of mortgage refinancing, the rise in housing prices, and Federal Reserve monetary policy.
2) We discuss the various structural factors seen as common to financial crises in a "fact and fantasy" framework, among them, transparency, complexity, ratings agencies and regulator modeling, and why, with all the advances in finance science and practice over the last decade, is the financial system seemingly no safer?
3)Looking to the future, I will list some of the potential risks which could further deepen the existing crisis and some proposals for action to reduce the vulnerability of the system. If time permits, discuss some of the opportunities that modern risk management can offer for improving the distribution of risk at the level of whole countries and thereby, improving significantly the prospects for economic growth and development, especially among smaller and developing countries.

Robert C. Merton
Harvard Business School
10.Nov 2008

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