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Scenario Analysis and the Real vs. Risk Neutral World

In the fourth segment of FINCAD’s five-part video series featuring John Hull, PhD and Alan White, PhD we posed the question, “What is the value of real world versus risk neutral modeling?”

Traditionally the derivatives business has been very concerned with the processes followed by market variables in a risk-neutral world. This is because their main focus has been on the valuation of derivatives. But now, things are changing. While risk neutral modeling is, and will likely remain, very important, we mustn’t forget that this is an artificial construct that can’t tell us how market variables behave in the real world. For this kind of insight, we need scenario analysis.

On this topic, Hull weighed in, “In the last few years we’ve seen scenario analysis growing in importance. Financial institutions want to know how things will turn out, for example, in the next year, two years or three years time. It’s not just about valuations anymore, it’s about other key aspects like liquidity and how firms can expect to survive. To do this sort of analysis, you need to work in the real-world, not the risk-neutral world. For this reason, I foresee that this concept of how you move from one measure to another measure is going to be increasingly critical going forward.”

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Models and Measures 1

Remember: a risk-neutral world is nothing more than an artificial construct. John Hull, PhD and Alan White, PhD discuss.