Submitted by Dabbing_Squid t3_xu6jpi in askscience
In the recent speculation of Credit Suisse, I see allot of Experts say while they might be having a rough patch they aren’t coming close to solvency. The little I understand is that certain derivates seem incredibly difficult to value and can rapidly change and nuke Banks since it’s based on the underlying value of other instruments. Which themselves might of been poorly conceived and poorly put together.
Certain financial instruments themselves seem to make markets act highly irrational and can make the true Value of companies and banks next to impossible to know in certain instances.
yetanotheryacht t1_iqv209k wrote
Derivatives have non-linear outcome on stochastic events. So you can not make linear predictions, only probabilistic guesses
For each derivative you model the probability ranges of their underlying assets changing value. You then take those outcomes to use for setting the expected value of the derivative. The problem is that this all assumes linear probability but the world is defined by big events, not small increments. So when a country invades another country or a pandemic hits, some of the underlying assets will change value in a highly unexpected way, and you probabilistic approach to pricing the derivative is wrong.
Think of derivatives as fire insurance: If you are the one who have sold the derivative you may have to be the one to pay out the insured amount. That is fine if only 1 in 10'000 houses catch fire, under normal conditions, but if 1000 houses are lost due to a wildfire, you have to pay out a lot more than you set aside because your model did not take this big event into account.