Why derivatives need models: the political economy of derivative valuation models[Derivatives: virtual values and real risks, Theory]

Derivatives markets continue to turn over enormous volumes and are an important part of financialised capitalism in the early twenty-first century. A surprising and yet key feature of these large and apparently liquid markets is that they seem to be bound up with the widespread use of mathematical valuation and risk management models by market participants. The paper investigates derivative models and risk management by highlighting the grounds for their emergence, their establishment and their influence on market developments.A political economy of derivatives markets provides insights into the essential nature of derivatives, defining them against the material circumstances in which they arise, and allows the logical development of valuation models and risk management as the necessary complement to the large-scale derivatives markets that have developed since the 1980s. The paper builds from finding prices for potential new trades to valuing completed trades and risk managing portfolios to show how and why valuation models and risk management are bound up with today’s derivatives markets.