Model risk pricing and hedging

I use Financial Economics theory to derive a measure of model risk with clear and actionable implications. The resulting “Model Risk Price” is based on the covariance between the payoffs associated with the model and the Stochastic Discount Factor, setting it fundamentally apart from the model accuracy statistics that have been typically used as model risk measures. Given that it is measured in financial terms, the Model Risk Price and its associated hedging strategies can also be intuitively communicated to non-technical audiences, such as investors, CEOs, other C-suite executives, and risk managers. From a practical standpoint, the paper addresses one of the most critical questions posed to risk managers by the firm’s investors: What is the precise impact of model risk on their investments, and what concrete actions can be taken to mitigate it. More broadly, the paper makes a seminal contribution to the literature by formally defining and economically measuring the risk of using a model, rather than simply estimating the uncertainty in its output as is currently done.