Model risk

Case studies: Merrill Lynch (1970s; $70m loss) - for stripped bonds, used a single par yield instead of separate annuity yield-curves and zero-coupon curves for the resultant IO and PO securities.^[1] NatWest (1997; £90m loss) - incorrect model specification, "a naive volatility input in their systems",^[1] for interest rate options and swaptions.^[2] Bank of Tokyo-Mitsubishi (1997; $83m loss) - a "systematic pricing bias"^[1] for out-of-the-money and Bermuda swaptions which had been calibrated to at-the-money vanilla swaptions.^[3] Barclays de Zoete Wedd (1997; £15m loss) - mispriced currency options.^[4] LTCM (1998; required $3.65 billion in recapitalization) - risk models had drastically under-estimated the risks of a profound economic crisis, due to an insufficient data-window and a lack of stress testing.^[5] National Australia Bank (2001; $2.2 Billion AUD loss) - its Homeside interest rate model made inconsistent use of rates.^[6]^[7] 2007–2008 financial crisis – Over-reliance on David X. Li's Gaussian copula model misprices the risk of collateralized debt obligations.^[8]

In finance, model risk is the risk of loss resulting from using insufficiently accurate models to make decisions, originally and frequently in the context of valuing financial securities.^[9]

Here, Rebonato (2002) defines model risk as "the risk of occurrence of a significant difference between the mark-to-model value of a complex and/or illiquid instrument, and the price at which the same instrument is revealed to have traded in the market".

However, model risk is increasingly relevant in contexts other than financial securities valuation, including assigning consumer credit scores, real-time prediction of fraudulent credit card transactions, and computing the probability of an air flight passenger being a terrorist. In fact, Burke regards failure to use a model (instead over-relying on expert judgment) as a type of model risk.^[10]

^ ^a ^b ^c Gibson, et al. (Spring 1999). "Interest rate model risk: An overview". The Journal of Risk. 1 (3): 37–62. doi:10.21314/JOR.1999.009.
^ "Model Validation and Backtesting". Archived from the original on 2009-04-03. Retrieved 2008-12-01.
^ "Controlling Model Risk". Archived from the original on 2008-12-07. Retrieved 2008-12-01.
^ Simmons, Katerina (1997). "Model Error" (PDF). New England Economic Review: 17–28. Evaluation of various finance models
^ See "Chapter 14 - Model Risk" in Crouhy, Galai and Mark.
^ Becky Gaylord (Sept. 8, 2001) "Oops! Bank Will Write Off $1.75 Billion", New York Times
^ "National Australia Bank chief promises review as share price drops". Australian Broadcasting Corporation. 12 June 2023.
^ "Recipe for Disaster: The Formula That Killed Wall Street". Wired. February 23, 2009.
^ "Model Risk" (pdf). 1996. Retrieved September 10, 2013.
^ http://www.siiglobal.org/SII/WEB5/sii_files/Membership/PIFs/Risk/Model%20Risk%2024%2011%2009%20Final.pdf^{[permanent dead link‍]}

[Gibson-1] Gibson, et al. (Spring 1999). "Interest rate model risk: An overview". The Journal of Risk. 1 (3): 37–62. doi:10.21314/JOR.1999.009.

[2] "Model Validation and Backtesting". Archived from the original on 2009-04-03. Retrieved 2008-12-01.

[3] "Controlling Model Risk". Archived from the original on 2008-12-07. Retrieved 2008-12-01.

[New_England_Econ_Review-4] Simmons, Katerina (1997). "Model Error" (PDF). New England Economic Review: 17–28. Evaluation of various finance models

[5] See "Chapter 14 - Model Risk" in Crouhy, Galai and Mark.

[6] Becky Gaylord (Sept. 8, 2001) "Oops! Bank Will Write Off $1.75 Billion", New York Times

[7:30_report-7] "National Australia Bank chief promises review as share price drops". Australian Broadcasting Corporation. 12 June 2023.

[Wired.com-8] "Recipe for Disaster: The Formula That Killed Wall Street". Wired. February 23, 2009.

[derman-model-risk-9] "Model Risk" (pdf). 1996. Retrieved September 10, 2013.

[Burke-risk-professional-interest-forum-10] ttp://www.siiglobal.org/SII/WEB5/sii_files/Membership/PIFs/Risk/Model%20Risk%2024%2011%2009%20Final.pdf^{[permanent dead link‍]}

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