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A Darwinian Theory of Model Risk

Author

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  • Claudio Albanese
  • 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)

  • Stefano Iabichino

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.

Suggested Citation

  • Claudio Albanese & Stéphane Crépey & Stefano Iabichino, 2021. "A Darwinian Theory of Model Risk," Post-Print hal-03910130, HAL.
    • Handle: RePEc:hal:journl:hal-03910130
    Note: View the original document on HAL open archive server: https://hal.science/hal-03910130
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    References listed on IDEAS

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    1. Carr, Peter, 1998. "Randomization and the American Put," The Review of Financial Studies, Society for Financial Studies, vol. 11(3), pages 597-626.
    2. Hull, John & White, Alan, 1990. "Pricing Interest-Rate-Derivative Securities," The Review of Financial Studies, Society for Financial Studies, vol. 3(4), pages 573-592.
    3. David Heath & Robert Jarrow & Andrew Morton, 2008. "Bond Pricing And The Term Structure Of Interest Rates: A New Methodology For Contingent Claims Valuation," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 13, pages 277-305, World Scientific Publishing Co. Pte. Ltd..
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    Cited by:

    1. Cyril Bénézet & Stéphane Crépey & Dounia Essaket, 2023. "Hedging Valuation Adjustment for Callable Claims," Working Papers hal-04057045, HAL.
    2. Cyril B'en'ezet & St'ephane Cr'epey & Dounia Essaket, 2023. "Hedging Valuation Adjustment for Callable Claims," Papers 2304.02479, arXiv.org.
    3. Stéphane Crépey, 2022. "Positive XVAs," Post-Print hal-03910135, HAL.

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