The usefulness of inaccurate models: Towards an understanding
of the emergence of financial risk management
Yuval Millo
a,
*
, Donald MacKenzie
b
a
Department of Accounting, London School of Economics and Political Science, Houghton Street, London WC2A 2AE, United Kingdom
b
School of Social and Political Studies, University of Edinburgh, Adam Ferguson Building, George Square, Edinburgh EH8 9LL, United Kingdom
article info
abstract
Is the growth of modern financial risk management a result of the accuracy and reliability
of risk models? This paper argues that the remarkable success of today’s financial risk man-
agement methods should be attributed primarily to their communicative and organiza-
tional usefulness and less to the accuracy of the results they produced. This paper traces
the intertwined historical paths of financial risk management and financial derivatives
markets. Spanning from the late 1960s to the early 1990s, the paper analyses the social,
political and organizational factors that underpinned the exponential success of one of
today’s leading risk management methodologies, the applications based on the Black–
Scholes–Merton options pricing model. Using primary documents and interviews, the
paper shows how financial risk management became part of central market practices
and gained reputation among the different organisational market participants (trading
firms, the options clearinghouse and the securities regulator). Ultimately, the events in
the aftermath of the market crash of October 1987 showed that the practical usefulness
of financial risk management methods overshadowed the fact that when financial risk
management was critically needed the risk model was inaccurate.
Ó 2008 Elsevier Ltd. All rights reserved.
Introduction
Financial risk management is one of the fastest growing
service industries in the business world. According to the
Global Association of Risk Professionals (GARP), one of
the leading trade associations in the field, there are cur-
rently more than 74,000 financial risk managers in finan-
cial institutions.
1
Dozens of academic and professional
institutions award degrees and diplomas in financial risk
management and these qualifications are gaining recogni-
tion by regulators and international certification bodies. At
the heart of this body of knowledge and practices (virtually
non-existent less than thirty years ago) is a set of financial
economic theories, employing a variety of statistical models
to assess and calculate the risks associated with a plethora of
financial assets and contracts. Many of these financial risk
management systems are proprietary and no reliable statis-
tics are published about their use, but it is estimated that the
daily transaction volume of financial products traded in or-
ganized exchanges that are managed using such methods
exceeds 50 million transactions,
2
with many more transac-
tions executed in over-the-counter markets. Is this remark-
able success an evidence of the predictive powers of
modern financial economics? Judging from a brief review
of several leading textbook in financial economics (Hull,
2005; McDonald, 2006; Stulz, 2002), the answer to this
question is a resounding ‘yes’: the accuracy and validity of
risk models and the applications that use them are said to
be tested and re-validated literally millions of times a day
in the markets.
0361-3682/$ - see front matter Ó 2008 Elsevier Ltd. All rights reserved.
doi:10.1016/j.aos.2008.10.002
* Corresponding author.
E-mail address: y.millo@lse.ac.uk (Y. Millo).
1
http://www.garp.com/about/archive.asp (accessed on 30th March,
2008).
2
http://www.sungard.com/sungard/ (accessed on 30th March, 2008).
Accounting, Organizations and Society 34 (2009) 638–653
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journal homepage: www.elsevier.com/locate/aos