BFS 2002

Poster Presentation

Model Risk and Regulatory Capital

Jeroen Kerkhof, Bertrand Melenberg, Hans Schumacher

In this paper we propose a general framework for quantification of model risk. This framework allows one to allocate regulatory capital to positions in a given market depending on the extent to which this market can be reliably modeled. Our approach is based on computing worst-case risk measures over sets of models that are in some appropriate sense close to a nominal model. The method is general in the sense that it can be applied with any of the usual risk measures such as Value-at-Risk and Tail Conditional Expectation. Inasfar as risk measures can also be used as pricing tools or as determinants of margin requirements, the paper provides a quantification of model risk in these settings as well. We present applications both to stock portfolios and to derivative products: we find that, for usual specifications, misspecification risk is much more important than estimation risk.