Chapter 8: Model Risk

Question 1

What is model risk?

Answer 1

The possibility of adverse consequences arising from decisions based on models that are incorrect.

Question 2

What are models used for?

Answer 2

Turning complex data into something actionable

Question 3

How did Long Term Capital Management (LCTM) use models?

Answer 3

Used complex mathematical models to arbitrage government bonds

Question 4

What are the 3 limiting assumptions of a model?

Answer 4

1. The shape of the distribution assumed by the model, e.g assuming normal on non normal data
2. Relationship between the past and the present
3. State of the market/business environment when the model was designed. E.g. Bull/Bear market

Question 5

What makes it easy to gauge the accuracy of a model?

Answer 5

Time lag between
Implementing the output of a model
Value of the implementation

This is why HFT is easy to assess, measure P/L

Question 6

What is the purpose of a risk workshop?

Answer 6

To consider potential operational risks as they can be hard to quantify as they happen infrequently