Introduction

Why do I consider this book to be relevant to the community of people involved in one way or another with financial modelling? Because the next big crisis already has the seeds planted and its roots are growing stronger and bigger by the day. There are already manifestations of model risk that led to substantial losses and it may sound cliché to say that this is only the tip of the iceberg. In 1987 Merrill Lynch reported losses of 300 million USD on stripped mortgage-backed securities because of an incorrect pricing model and five years later in 1992 J.P. Morgan lost about 200 million USD in the mortgage-backed securities market because of inadequate modelling of prepayments. Bank of Tokyo/Mitsubishi announced in March 1997 that its New York-subsidiary dealing with derivatives had incurred an $83 million loss because of their internal pricing model overvalued a portfolio of swaps and options on USD interest rates. [Dowd (2002)] pointed out that the loss was caused by wrongly using a one-factor Black-Derman-Toy (BDT) model to trade swaptions. The model was calibrated to market prices of ATM swaptions but used to trade out-of-the-money (OTM) Bermudan swaptions, which was not appropriate. With the benefit of hindsight it is known now that pricing OTM swaptions and Bermudan swaptions requires multi-factor models. Also in 1997, NatWest Capital Markets reported a £50 million loss because of a mispriced portfolio of German and U.K. interest rate derivatives on the book of a single derivatives trader in London who fed his own estimates of volatility into a model pricing OTC interest rate options with long maturities. The estimates were high and led to fictitious profits. It is not clear whether the trader simply inflated the volatility estimate or she/he came up with the estimate that was more “convenient” to her/him. [Elliott (1997)] pointed out that these losses were directly linked to model risk. [Williams (1999)] remarked that model risk was not included in standard risk management software and in 1999 about 5 billion USD losses were caused by model risk…