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Summer 2004 CalBusiness  
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Pierre Collin-Dufresne Improves Methods to Manage Risk

With the growing internationalization of trade and the integration of financial markets has come greater risk in areas such as foreign exchange, interest rates, and commodity prices. To help firms hedge their exposures to risks, financial markets offer specially designed “insurance” contracts known as derivatives, but financial economists have discovered that market prices do not quite conform to the insights of established theories.

Associate Professor of Finance Pierre Collin-Dufresne tries to shed light on this through two main lines of research: fixed-income securities and credit derivatives. He examines, for example, how the pricing of caps (contracts that protect an investor from paying interest beyond a certain percentage on things like loans) compares to that of swaps (contracts that allow an investor to switch from paying interest at a fixed rate on things like mortgages to paying a floating interest rate when such rates are lower). “Cap prices actually prove to be more volatile than standard theory would predict, and in ways that seem inconsistent with movements in swap rates,” Collin-Dufresne says.

He and Robert Goldstein of the University of Washington in Saint Louis have developed a model that shows that the greater cap-price volatility may, in fact, be perfectly consistent with dynamic asset pricing theory once real-world factors are taken into account. “We provide a statistical method that a bank can use to set prices for these contracts that is more consistent with the data,” he says. “This should allow them to do hedging and pricing in a more efficient way.”

Looking at bond prices for firms with varying degrees of default risk, Collin-Dufresne has similarly found that basic option pricing theory does not accurately reflect market behavior. “My model tries to account for factors such as the possibility that firms are changing their capital structure, which allows them to change their risk level,” he says. “This, in turn, affects the prices of their bonds.”

Collin-Dufresne also studies “contagion risk” – the tendency of one firm's bankruptcy to affect the default risk of other firms in a kind of domino effect. Recently, he has been exploring the derivatives markets for commodities such as oil, gold, silver, and copper.

He holds a Ph.D. from the HEC School of Management in Paris and has been a faculty member at Carnegie Mellon's Graduate School of Industrial Administration.

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Pierre Collin-Dufresne

Pierre Collin-Dufresne
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