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Model error

  • Katerina Simons
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    Modern finance would not have been possible without models. Increasingly complex quantitative models drive financial innovation and the growth of derivatives markets. Models are necessary to value financial instruments and to measure the risks of individual positions and portfolios. Yet when used inappropriately, the models themselves can become an important source of risk. Recently, several well-publicized instances occurred of institutions suffering significant losses attributed to model error. This has sharpened the interest in model risk among financial institutions and their regulators.> This article describes various models and discusses model errors characteristic of two types -- valuation models for individual securities, and models of market risk. It also reviews a number of practical issues related to model development and describes the approach taken by bank regulators to model risk. The author points out that a trade-off almost always exists between the realism and the analytical tractability of a model. Striking the right balance in the face of this trade-off, she writes, and maintaining it through changing market conditions for different financial instruments, is more art than science and requires considerable experience and judgment.

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    File URL: http://www.bostonfed.org/economic/neer/neer1997/neer697b.htm
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    File URL: http://www.bostonfed.org/economic/neer/neer1997/neer697b.pdf
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    Article provided by Federal Reserve Bank of Boston in its journal New England Economic Review.

    Volume (Year): (1997)
    Issue (Month): Nov ()
    Pages: 17-28

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    Handle: RePEc:fip:fedbne:y:1997:i:nov:p:17-28
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    1. Merton, Robert C., 1975. "Option pricing when underlying stock returns are discontinuous," Working papers 787-75., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    2. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    3. Bollerslev, Tim, 1986. "Generalized autoregressive conditional heteroskedasticity," Journal of Econometrics, Elsevier, vol. 31(3), pages 307-327, April.
    4. Benoit Mandelbrot, 1963. "The Variation of Certain Speculative Prices," The Journal of Business, University of Chicago Press, vol. 36, pages 394.
    5. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(3), pages 311-25, August.
    6. Engle, Robert F, 1982. "Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of United Kingdom Inflation," Econometrica, Econometric Society, vol. 50(4), pages 987-1007, July.
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