Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk, 2nd Edition

CHAPTER 8

Model Risk

Any book on financial risk management needs to address the subject of model risk, the risk that theoretical models used in pricing, trading, hedging, and estimating risk will turn out to produce misleading results. This book, which emphasizes quantitative reasoning in risk management, pays particularly close attention to how models can be used and misused in the risk management process.

Since the publication of the first edition of this book, the financial risk management focus on model risk has intensified. In the wake of the 2007–2008 crisis, as we discuss in Sections 5.1 and 5.2.5.3, there have been accusations that model failure was one of the root causes of the meltdown. When a widely discussed article has the title “Recipe for Disaster: The Formula That Killed Wall Street” (Salmon 2009), it is clear that model risk needs to be addressed with a sense of urgency.

Fortunately, in addition to this sense of crisis surrounding model risk, the past several years have witnessed greater attention to analysis of how model risk can be controlled. Concise, excellent articles by Derman (2001) and Rebonato (2003) are now recognized as touchstones for the analysis of model risk. Morini (2011) is the first thorough book-length treatment of model risk. The Federal Reserve and Office of the Comptroller of the Currency joint document for “Supervisory Guidance on Model Risk Management,” which I will reference as FRB (2011), and the Basel Committee on Banking Supervision's ...