A Darwinian Theory of Model Risk

19 Pages Posted: 24 Mar 2020

See all articles by Claudio Albanese

Claudio Albanese

Global Valuation; CASS School of Business

Stéphane Crépey

Université d'Évry - Equipe d'Analyse et Probabilites

Stefano Iabichino

JP Morgan

Date Written: February 19, 2020

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

Suggested Citation

Albanese, Claudio and Crépey, Stéphane and Iabichino, Stefano, A Darwinian Theory of Model Risk (February 19, 2020). Available at SSRN: https://ssrn.com/abstract=3544862 or http://dx.doi.org/10.2139/ssrn.3544862

Claudio Albanese (Contact Author)

Global Valuation ( email )

9 Devonshire Sq.
London, London EC2M 4YF
United Kingdom

CASS School of Business ( email )

106 Bunhill Row
London, England EC1Y 8TZ
United Kingdom

Stéphane Crépey

Université d'Évry - Equipe d'Analyse et Probabilites ( email )

Boulevard des Coquibus
F-91025 Evry Cedex
France

Stefano Iabichino

JP Morgan ( email )

London
United Kingdom

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