Measuring and Managing Risk in Innovative Financial Instruments Stuart M. Turnbull  Bauer College of Business, University of Houston April 27, 2010 Abstract This paper discusses the di¢cult challenges of measuring and managing risk of innovative nancial products. To measure risk requires the ability to rst identify the di/erent dimensions of risk that an innovation introduces. The list of possible factors is long: model restrictions, illiquidity, limited ability to test models, product design, counterparty risk and related managerial issues. For measuring some of the di/erent dimensions of risk the implications of limited available data must be addressed. Given the uncertainty about model valuation, how can risk managers respond? All parties within a company - senior management, traders and risk managers - have important roles to play in assessing, measuring and managing risk of new products. 1 Introduction In the current credit crisis, the issues of improper valuation and inadequate risk management in the use of credit derivatives have been at the center of the credit market turmoil. There has been much discussion about the use of such instruments as mortgage backed securities, collateralized debt obligations and credit default swaps. The crisis raises the questions of how do we measure the risk of innovative nancial products and how do we manage the risk? Innovative nancial instruments are typically illiquid and pose several challenges for  I am grateful for comments and suggestions from M. Crouhy, R. Jarrow, C. Pirrong, D. Rowe, C. Smithson, L. Wakeman and seminar participants at the Bauer College and the Financial Innovation & Crisis Conference, organized by the Federal Reserve Bank of Atlanta. 1