Assessing Financial Model Risk

TL;DR

This paper introduces three quantitative measures of model risk to improve risk measurement accuracy, providing flexible tools for assessing the impact of model choice within a class, supported by practical examples.

Contribution

It proposes three new measures of model risk—absolute, relative, and local—that enhance the assessment and management of model risk in financial modeling.

Findings

The measures are practical and tractable.

They offer flexibility for different risk assessment purposes.

Illustrated with relevant examples.

Abstract

Model risk has a huge impact on any risk measurement procedure and its quantification is therefore a crucial step. In this paper, we introduce three quantitative measures of model risk when choosing a particular reference model within a given class: the absolute measure of model risk, the relative measure of model risk and the local measure of model risk. Each of the measures has a specific purpose and so allows for flexibility. We illustrate the various notions by studying some relevant examples, so as to emphasize the practicability and tractability of our approach.