MODEL RISK

A model is a graphical, mathematical or physical or verbal representation or simplified version of a

concept, phenomena, relationship, structure, system or aspect of the real world. In an attempt to simplify
the real world, models make multiple assumptions and approximations while trying to remain simple, easy
to comprehend and implement. If a model fails to replicate the real world, it will produce improper outputs
and if decisions are made based on those outputs, organisations will incur losses. Models are playing an
increasing role in supporting financial services business.
Model risk is risk of loss arising from use of models. Model risks arises either from the data used in the
model, assumptions of the model, methodology, errors in the development of the model, or
implementation of the model. Most models are derived under the assumptions of perfect capital markets
but, in practice, market imperfections lead to substantial and persistent differences between the way
markets behave and the results generated by models. Model risk is considered a subset of operational
risk
Model risk can have profound financial and reputational implications and can lead to costly errors or
missed opportunities. Without adequate governance, models can significantly impair business decision
making. Examples of model risk cases include Mouchels Pension Fund, JP Morgan Chase, US Federal
Reserve, Long Term Capital Management etc.
Problems relating to models can be grouped into two main groups:
1. The model is irrelevant. There is no solid financial theory to support the model, or empirical
evidence to verify its validity. This is mostly the case with trading models that attempt to forecast
stock prices or exchange rates.

2. The model is incorrect. Derivatives trading depends heavily on the use of mathematical models
that make use of complex equations and advanced mathematics. In the simplest sense, a model is
incorrect if there are mistakes in the set of equations, or in the solution of a system of equations. A
model is also incorrect if it is based on wrong assumptions about the underlying asset.

TYPOLOGY OF MODEL RISK

The following are the main categories/types of model risk
Erroneous Model and Model Misspecification
Model specification is the process of constructing a model and it entails selecting the functional form of
the model and choosing the variables to include. The choice of functional form and variables must
represent the true and relevant aspects of the data-generating process. Examples of erroneous model
and model misspecification includes: errors in the analytical solution, misspecifying the underlying
stochastic process, missing risk factors, e.g. using a single-factor model where a multi-factor is required;
missing variables such as transaction costs and liquidity, misclassifying or misidentifying the underlying
asset, including irrelevant variables.
Incorrect Implementation of the Model
This refers to the risk that one can make error (accidentally or intentionally) when implementing a model.
Some models require extensive programming and complex computations which involve copula functions.
Incorrect implementation of the model includes bugs in the program and approximation errors, insufficient
numbers of simulation run, non-simultaneous data feeds.
Incorrect Model Calibration
Model calibration involves estimating intervals, dealing with outliers, estimating and revising estimated
parameters, choosing statistical techniques such as least squares and maximum likelihood. Incorrect
model calibration includes: estimation errors, choosing wrong parameters, fitting wrong parameters etc.
Market Data Processing
The quality of a model depends heavily on the accuracy of the input parameter values that feed the
model. The old adage \garbage in-garbage out" should never be forgotten when implementing models
that require the estimation of several parameters. Volatilities and correlations are the hardest input
parameters to estimate. Length of the sampling period and inaccurate date are the most frequent
problems in estimating values. Data maybe inaccurate, insufficient, outdated and this may lead to
inaccurate outputs.
Model Misapplication
A model can be found to be mathematically correct and consistent with finance theory, and to make use
of accurate data, and yet be misapplied to a given situation. For example, applying a model to value
derivatives with more features than its original design; the model maybe inappropriate under current
market conditions, or some of its assumptions may have become invalid due to changing market
conditions.

SELF DIRECTED LEARNING ACTIVITY

Discuss the various strategies that can be used by insurance companies to manage model risk