Measuring and managing risk in innovative financial instruments

ABSTRACT This paper discusses the difficult challenges of measuring and managing the risk of innovative financial products. Measuring risk requires the ability to first identify the different dimensions of risk that an innovation introduces. The list of possible factors is long: model restrictions, illiquidity, limited ability to test models, product design, counterparty risk and related managerial issues. In order to measure some of the different dimensions of risk, the implications of limited data availability must be addressed. Given the uncertainty about model valuation, how can risk managers respond? All parties within a company (senior management, traders and risk managers) have important roles to play in assessing, measuring and managing the risk of new products.