The usefulness of inaccurate models: financial risk management 'in the wild'

Yuval Millo and Donald MacKenzie

Abstract

ABSTRACT

Is the growth of modern financial risk management a result of the accuracy and reliability of risk models? In this paper we argue that the remarkable success of today's financial risk management methods should be attributed primarily to their communicative and organizational usefulness and less to the accuracy of the results they produce. In this paper we trace the intertwined historical paths of financial risk management and financial derivatives markets. Spanning from the late 1960s to the early 1990s, we analyze the social, political and organizational factors that underpinned the exponential success of one of today's leading risk management methodologies, the applications based on the Black-Scholes-Merton options pricing model. Using primary documents and interviews, the paper shows how financial risk management became part of central market practices and gained a reputation among the different organizational market participants (trading firms, the options clearing house and the securities regulator). Ultimately, the events in the aftermath of the market crash of October 1987 showed that the practical usefulness of financial risk management methods overshadowed the fact that when financial risk management was critically needed the risk model was inaccurate.