Market Risk with Interdependent Choice

Risks faced by traders from price movements are sometimes magni¿ed by the actions of other traders. Risk management systems which neglect this feature may give a seriously misleading picture of the true risks. The hazards arising from this potential blindspot are at their most dangerous when the prevailing conventional wisdom lulls traders into a false sense of security on the attractivenss of a trading position. The efforts of one trader to reverse his trade makes more acute the Paper prepared for the conference on liquidity risk, Frankfurt, 30 June 1st July 2000. A nontechnical version of this paper entitled “Risk Management with Interdependent Choice” appeared in the Oxford Review of Economic Policy (Autumn 1999) and reprinted in the Bank of England Financial Stability Review, November 1999. need to follow suit on the part of others. For markets dominated by traders with short time horizons, such interdependence leads to exaggerated price movements. Estimates of ‘value at risk’ which recognize such interdependence of actions can diverge substantially from those given by conventional techniques.