Robust Capital Requirements with Model Risk

42 Pages Posted: 20 Jul 2013 Last revised: 14 Jul 2014

See all articles by Claudia Ravanelli

Claudia Ravanelli

Center for Finance and Insurance

Pauline M. Barrieu

London School of Economics & Political Science (LSE)

Multiple version iconThere are 2 versions of this paper

Date Written: April 16, 2014

Abstract

We investigate capital requirements based on Value at Risk (V@R) and Average Value at Risk (AV@R) when the bank's econometric model only approximately describes the true, unknown return generating process, as is often the case in practice. We provide a simple formula for such capital requirements that uses a first order Taylor expansion of V@R and AV@R around a model confidence parameter. This formula allows the bank to reflect the confidence of the econometric model into capital requirements in a theoretically consistent manner. We derive feasible upper bounds on the first order approximation of the true, unknown V@R and AV@R. An empirical application to daily S&P 500 returns shows that the upper bounds are tight and provide valuable information for assessing capital requirements in the presence of model risk.

Keywords: Value at Risk, Average Value at Risk, model risk, Robust Statistics

JEL Classification: C14, C15, C23, C59

Suggested Citation

Ravanelli, Claudia and Barrieu, Pauline M., Robust Capital Requirements with Model Risk (April 16, 2014). Available at SSRN: https://ssrn.com/abstract=2295959 or http://dx.doi.org/10.2139/ssrn.2295959

Claudia Ravanelli (Contact Author)

Center for Finance and Insurance ( email )

Plattenstrasse 14
Zürich, 8032
Switzerland
+41 44 634 29 81 (Phone)

HOME PAGE: http://www.bf.uzh.ch/cms/en/ravanelli.claudia.html

Pauline M. Barrieu

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

HOME PAGE: http://stats.lse.ac.uk/barrieu/

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