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Model error

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  • Katerina Simons

Abstract

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.

Suggested Citation

  • Katerina Simons, 1997. "Model error," New England Economic Review, Federal Reserve Bank of Boston, issue Nov, pages 17-28.
    • Handle: RePEc:fip:fedbne:y:1997:i:nov:p:17-28
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    References listed on IDEAS

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    2. Benoit Mandelbrot, 2015. "The Variation of Certain Speculative Prices," World Scientific Book Chapters, in: Anastasios G Malliaris & William T Ziemba (ed.), THE WORLD SCIENTIFIC HANDBOOK OF FUTURES MARKETS, chapter 3, pages 39-78, World Scientific Publishing Co. Pte. Ltd..
    3. Merton, Robert C., 1976. "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 125-144.
    4. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(3), pages 311-325, August.
    5. 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 637-654, May-June.
    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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    Cited by:

    1. Chen, Fen-Ying & Liao, Szu-Lang, 2009. "Modelling VaR for foreign-asset portfolios in continuous time," Economic Modelling, Elsevier, vol. 26(1), pages 234-240, January.
    2. Carol Alexander & Jose Maria Sarabia, 2010. "Endogenizing Model Risk to Quantile Estimates," ICMA Centre Discussion Papers in Finance icma-dp2010-07, Henley Business School, University of Reading.
    3. Katerina Simons, 2000. "Use of value at risk by institutional investors," New England Economic Review, Federal Reserve Bank of Boston, issue Nov, pages 21-30.
    4. Kato, Toshiyasu & Yoshiba, Toshinao, 2000. "Model Risk and Its Control," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 18(2), pages 129-157, December.
    5. Chung, Huimin & Lee, Chin-Shen & Wu, Soushan, 2002. "The effects of model errors and market imperfections on financial institutions writing derivative warrants: Simulation evidence from Taiwan," Pacific-Basin Finance Journal, Elsevier, vol. 10(1), pages 55-75, January.
    6. Ralph C. Kimball, 2000. "Failures in risk management," New England Economic Review, Federal Reserve Bank of Boston, issue Jan, pages 3-12.
    7. Daniela MATEI & Dragos CRISTEA & Alexandru CAPATINA, 2012. "Risk Management in the Age of Turbulence - Failures and Challenges," Economics and Applied Informatics, "Dunarea de Jos" University of Galati, Faculty of Economics and Business Administration, issue 2, pages 17-22.

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