Model Risk and Regulatory Capital
54 Pages Posted: 24 Feb 2002
Date Written: February 22, 2002
Abstract
In this paper we propose a general framework for quantification of model risk. This framework allows us to allocate regulatory capital to positions in a given market depending on the extent to which this market can be reliably modeled. Our approach is based on computing worst-case risk measures over sets of models that are in some appropriate sense close to a nominal model. The method is general in the sense that it can be applied with any of the usual risk measures such as Value-at-Risk and Tail Conditional Expectation. Inasfar as risk measures can also be used as pricing tools or as determinants of margin requirements, the paper provides a quantification of model risk in these settings as well. We present applications both to stock portfolios and to derivative products; we find that for usual specifications misspecification risk is typically much more important than estimation risk.
Keywords: Model risk, Capital requirements, (Coherent) risk measurement, Derivative pricing models
JEL Classification: G12, G18
Suggested Citation: Suggested Citation
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