Modeling complexity
Modeling precisely the macro-economic, micro-economic and contractual details related parameters influencing expected cash-flows of a given contract is a very complicated business.
Usually assumptions are taken and bundled into higher-order models. What does this buzzword of mine mean? Let's take an example:
Credit risk, i.e. the risk that a counterparty in a contract defaults, is driven by multiple factors that are very difficult to observe on one hand and model on the other hand. To solve this problem there are on one hand external rating agencies, like Moody’s, publishing "rating" of major counterparties (AAA means they have a very low probability of default and CCC a very high). To these ratings are associated standardized default probabilities and standardized credit spread curves, i.e. curves that, if added to the market expectation curves, used for discounting purpose give the price of the contract without applying difficult assumptions. I.e. we simply assume that if a contract is made with a more risky counterparty then the expected return of this contract should be higher by the amount defined by the spread curve.
Ok this post will need some refactoring, after second reading I don't even understand it myself.... sorry for that. :)
posted by Walter @ 1:33 PM
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