Perturbation Methods in Credit Derivatives

CHAPTER 16Model Risk Management Strategies

16.1 INTRODUCTION

Much effort is currently being invested into managing the risk faced by financial institutions as a consequence of model uncertainty. One strand to this effort is an increased level of regulatory scrutiny of the performance of the model validation function, both in terms of ensuring that adequate testing is performed of all models used for pricing and risk management purposes and of enforcing a governance policy that only models so tested are so used. As is stated in the Federal Reserve's Supervision and Regulation Letter of US Federal Reserve [2011]

An integral part of model development is testing, in which the various components of a model and its overall functioning are evaluated to show the model is performing as intended; to demonstrate that it is accurate, robust, and stable; and to evaluate its limitations and assumptions.

Another concern is model risk monitoring and management. Here the idea is that, having validated models and examined the associated uncertainty, the risk department should monitor and report on the risk faced by a financial institution, ideally so that senior management can, based on “risk appetite”, make informed decisions about model usage policy. According to US Federal Reserve [2011]

Validation activities should continue on an ongoing basis after a model goes into use to track known model limitations and to identify any new ones. Validation is an important check during periods of benign ...