Chapter 10: Trading Uncertainty
Like current financial markets in general, the market of derivatives produces the future and produces risk. Conversely, however, what actually happens is often different from what operators (and most theories) think will happen. Risk management is based on an assumption, one implicit in the techniques prevalent in the 1970s and involved in the generation of their calculations, that unpredictable risk behaves in a predictable way. Our inability to know the trends of the world generates risk. However, we can know the trends of risk. Even if our expectations are often wrong, we can at least expect to be able to obtain a certain kind of security from risk calculations (section 1). Markets are unpredictable because we cannot know if they will move upwards or downwards, if an asset will display good or bad behaviour. Volatility measures these changes and increases when turbulence (of the market or of an asset) rises. The financial techniques for risk management assume an ability to control this unpredictability. This assumption is made because, even though one cannot know in which direction the market will go, one expects to be able to know how volatility will move. In calculating implied volatility, one should be able to predict whether the movements will be broad or narrow, fast or slow (even without predicting if they will go up or down). Against these movements, one seeks protection through various strategies that compensate for them, allowing one to operate with risk without risk (section 2). This has seemed to work...
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