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Oxf Rev Econ Policy 1999; 15:52-62
© 1999 Oxford University Press and Oxford Review of Economic Policy Ltd

Article

Risk management with interdependent choice

S Morris0
HS Shin1
0 Yale University, USA
1 Nuffield College, Oxford, UK

Abstract

Risks faced by traders from price movements are sometimes magnified by the actions of other traders. Risk-management systems which neglect this feature may give a seriously misleading picture of the true risks. The hazards arising from this potential blindspot are at their most dangerous when the prevailing conventional wisdom lulls traders into a false sense of security on the attractiveness of a trading position. The efforts of one trader to reverse his trade makes more acute the need to follow suit on the part of others. For markets dominated by traders with short time horizons, such interdependence leads to exaggerated price movements. Estimates of 'value at risk' which recognize such interdependence of actions can diverge substantially from those given by conventional techniques.


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