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"One important measurement issue concerns the fat tails problem that I mentioned earlier. VAR is concerned with extreme outcomes. If the tails of the probability distributions we are using are too thin, our VAR measures are likely to be too low."
Extreme
"Yes, our tree has an interesting shape. The center branches reflect the shape of the zero curve. When extreme parts of the tree are reached the branching pattern changes to accommodate the mean reversion."
Extreme
"There are challenges in terms of the measurement of VAR for what are known as nonlinear derivatives, where things like gamma and vega are important dimensions of the risk."
Risk
"We started giving presentations at practitioner conferences in 1986, and since then all of our derivatives research has been stimulated by contact with practitioners."
Giving
"Briefly speaking, our conclusion is that stochastic volatility does not make a huge difference as far as the pricing is concerned if you get the average volatility right. It makes a big difference as far as hedging is concerned."
Difference
"When interest rates are high you want the average direction in which interest rates are moving to be downward; when interest rates are low you want the average direction to be upward."
Direction
"The real challenge was to model all the interest rates simultaneously, so you could value something that depended not only on the three-month interest rate, but on other interest rates as well."
Challenge
"Alan White and I spent the next two or three years working together on this. We developed what is known a stochastic volatility model. This is a model where the volatility as well as the underlying asset price moves around in an unpredictable way."
Years
"We concluded that you cannot rely on delta hedging alone. It sounds simplistic to say that now, but back then, this was the sort of thing people were only just beginning to realize."
People
"The HoLee model was the first term structure model. I remember reading their paper soon after it was published and as it was fairly different from many of the other papers that I had read, I had to read it quite a few times. I realized that it was a really important paper."
First
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