Model risk describes the risk/loss associated with over-relying on modeling for decision making. To construct Portfolio 1 and 2, we had to rely on a model/theory. Moreover, the previous analysis demonstrates the impact of model risk on performance and the sensitivity of our findings to the selection of the model’s inputs. For instance, Portfolio 2 requires more specifications than Portfolio 1, since it also depends on the estimates of the mean returns. In particular, model risk could arise to
•Incorrect model specification – false estimates for µi and σi
•Inapplicability of the model – drawbacks of MV optimization
Given your comprehension of model risk so far, write an essay of three paragraphs (maximum)
addressing each of the following issues:
•How errors in modeling assumptions can introduce model risk?
•How model risk can arise in the implementation of a model?
- Talk about procedures risk managers can use to mitigate model risk. For instance, what is the role of MC methods in mitigating model risk?
- So far, we have focused on equity and market risk management. Nonetheless, given your understanding of model risk, refer to the collapse of Long Term Capital Management (LTCM) in 1998 and try to relate to the impact of model risk on this event. In other words, how did model risk impact the collapse of LTCM?
Feel free to add examples and numbers from your previous results to strengthen your response to each of the above. Moreover, I recommend the following readings to further understand model risk and learn about the collapse of LTCM.
- Chapter 15 from Michel Crouhy, Dan Galai and Robert Mark, The Essentials of Risk Man-agement, 2nd Edition (New York, NY: McGraw-Hill, 2014).
- Business Snapshot 22.1 from Chapter 2 from John C. Hull, Risk Management and Financial Institutions, 4th Edition (Hoboken, NJ: John Wiley & Sons, 2015).