A Darwinian Theory of Model Risk

Abstract

Performance assessment of derivative pricing models revolves around a comparative model-risk analysis. From among the plethora of econometrically unrealistic models, the ones that survive Darwinian selection tend to generate systematic short term profits while exposing the bank to long term risks.

This article puts forward an ex ante methodology to analyse this pattern for the broad class of structures, whereby a dealer buys long-term convexity from investors and resells hedges to be used for risk management purposes. As a particular case, we consider callable range accruals in the US dollar, a product which has been traded in size in recent years and is currently being unwound. We find 3d animations useful to visualize sources of model risk.

Keywords: Model Risk, Structured Products, Short Rate Models

JEL Classification: D81, G01, G13, G32