Handling model risk with XVAs

TL;DR

This paper extends the concept of hedging valuation adjustment (HVA) to address model risk in financial institutions, emphasizing the importance of risk-adjusted reserves and suggesting local models may be better excluded than managed via reserves.

Contribution

It introduces a model risk-focused HVA framework that integrates with bank valuation and capital calculations, highlighting the significance of excluding local models.

Findings

HVA can be adapted to quantify model risk in valuation.

Model risk effects are significant enough to warrant exclusion of local models.

Risk-adjusted reserves are crucial for managing model risk effectively.

Abstract

In this paper we revisit Burnett (2021) \& Burnett and Williams (2021)'s notion of hedging valuation adjustment (HVA), originally intended to deal with dynamic hedging frictions such as transaction costs, in the direction of model risk. The corresponding HVA reconciles a global fair valuation model with the local models used by the different desks of the bank. Model risk and dynamic hedging frictions indeed deserve a reserve, but a risk-adjusted one, so not only an HVA, but also a contribution to the KVA of the bank. The orders of magnitude of the effects involved suggest that local models should not so much be managed via reserves, as excluded altogether.