A Darwinian Theory of Model Risk

Claudio Albanese, Stéphane Crépey () and Stefano Iabichino
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Stéphane Crépey: UFR Mathématiques UPCité - UFR Mathématiques [Sciences] - Université Paris Cité - UPCité - Université Paris Cité, LPSM (UMR_8001) - Laboratoire de Probabilités, Statistique et Modélisation - SU - Sorbonne Université - CNRS - Centre National de la Recherche Scientifique - UPCité - Université Paris Cité

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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 the Darwinian selection tend to generate systematic short-term profits while exposing the bank to long-term risks. This article proposes an ex-ante methodology to analyze the model-risk pattern for the broad class of structures, whereby a dealer buys long-term convexity from investors and resells hedges for risk management purposes. As a particular case, we consider callable range accruals in the US dollar, a product that has been traded in size in recent years and is currently generating material losses. To visualize the sources of model-risks, we use 3d animations.

Date: 2021
Note: View the original document on HAL open archive server: https://hal.science/hal-03910130v1
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Citations: View citations in EconPapers (3)

Published in Risk, 2021, ⟨10.2139/ssrn.3544862⟩

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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-03910130

DOI: 10.2139/ssrn.3544862

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