Model Risk for Market Risk Modeling

In 'THE RISK MODELING RISK EVALUATION HANDBOOK: RETHINKING FINANCIAL RISK MANAGEMENT METHODOLOGIES IN THE GLOBAL CAPITAL MARKETS', G. Gregoriou, C. Hoppe, and C. Wehn, eds, McGraw-Hill, 2010

Posted: 26 Mar 2010 Last revised: 29 Dec 2016

See all articles by Jason C. Hsu

Jason C. Hsu

Rayliant Global Advisors; Research Affiliates, LLC; University of California, Los Angeles - Anderson School of Business

Shane D. Shepherd

Research Affiliates, LLC

Vitali Kalesnik

Research Affiliates LLC

Date Written: November 2, 2010

Abstract

Standard risk management approaches fail to consider parameter uncertainty, which has led to improper risk management. Blind faith in parameter estimates has too often led to blind faith in the resulting VAR outputs, and when these estimates are too often exceeded the proposed solution is commonly to fatten up the tails by using exotic distributions. We show, however, that directly modeling the uncertainty in mean and variance returns using standard lognormal distributions can result in posterior distributions with high degrees of skewness and kurtosis. If we accept a simple world of time-varying expected returns and variances, the resulting uncertainty around these constantly shifting parameters places us squarely in this world of interesting and effective posterior distributions.

Keywords: Risk Modeling, Parameter Uncertainty

JEL Classification: G10, G12

Suggested Citation

Hsu, Jason C. and Shepherd, Shane D. and Kalesnik, Vitali, Model Risk for Market Risk Modeling (November 2, 2010). In 'THE RISK MODELING RISK EVALUATION HANDBOOK: RETHINKING FINANCIAL RISK MANAGEMENT METHODOLOGIES IN THE GLOBAL CAPITAL MARKETS', G. Gregoriou, C. Hoppe, and C. Wehn, eds, McGraw-Hill, 2010. Available at SSRN: https://ssrn.com/abstract=1575042

Jason C. Hsu (Contact Author)

Rayliant Global Advisors ( email )

Hong Kong

Research Affiliates, LLC ( email )

620 Newport Center Dr
Suite 900
Newport Beach, CA 92660
United States

HOME PAGE: http://www.jasonhsu.org

University of California, Los Angeles - Anderson School of Business

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Shane D. Shepherd

Research Affiliates, LLC ( email )

620 Newport Center Drive
Suite 900
Newport Beach, CA 92660
United States

Vitali Kalesnik

Research Affiliates LLC ( email )

620 Newport Center Dr
Ste 900
Newport Beach, CA 92660
United States
949-325-8717 (Phone)
949-325-8917 (Fax)

HOME PAGE: http://researchaffiliates.com/index.htm

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