Model Risk

Abstract

Models are an inevitable feature of modern finance, and model risk is inherent in the use of models. In this article we stress the technical elements of model risk. Models are susceptible to errors: from incorrect assumptions about price dynamics and market interactions, from implementing a model wrongly, from inaccurate estimation of volatilities and correlations and other inputs that are not directly observable and must be forecasted. We also discuss how to mitigate model risk.

Using Public Televisions Trillion Dollar Bet As A Primer On Financial Risk

“…(The website for "Gambling on Derivatives", www.ex.ac.uk/, contains information on derivative terminology and related information on financial scandals). [2] Swaps, currency futures, and commodity futures have all been used to manage investment risk. Describe each of the above.…”

“…How could an option be used to control risk in financial markets? [2] Describe each of the determinants of an option"s value and how each may affect the option"s price: stock price, strike price, volatility of the underlying asset, maturity date, and risk free interest rate. [3] Describe the basic notion of dynamic hedging as explained in the video (the use of opposite positions, equities and options, for example, on a continuous time path).…”

Model risk of contingent claims

“…Galai 1977, Merton et al 1978, Merton et al 1982, Figlewski 1998; overviews are given in e.g. Derman (1996), Crouhy et al (1998), Hénaff and Martini (2011) and Morini (2011). A large number of papers analyse the variation in prices and hedging strategies across different models, typically for certain classes of models or payoffs (e.g.…”

Model misspecification analysis for bond options and Markovian hedging strategies

“…Most papers are limited to a typology of model risk (see Crouhy et al 1998;Gibson et al 1999) or focus on the fit or the prediction of option prices (see for instance Flesaker 1993;Amin and Morton 1994;Bakshi et al 1997; Moraleda and Vorst 1997;Buhler et al 1999;Jagannathan et al 2003;Longstaff et al 2001a, b). It is only recently that a few papers have started examining the hedging of interest rate contingent claims for some specific products and models (see for instance Andersen and Andreasen 2001;Gupta and Subrahmanyam 2001;Fan et al 2001;Driessen et al 2003).…”