Understanding and Managing Model Risk: A Practical Guide for by Massimo Morini

By Massimo Morini

A consultant to the validation and possibility administration of quantitative types used for pricing and hedging

Whereas the vast majority of quantitative finance books concentrate on arithmetic and danger administration books specialize in regulatory facets, this booklet addresses the weather ignored by means of this literature--the dangers of the types themselves. This publication begins from regulatory matters, yet interprets them into sensible feedback to minimize the possibility of version losses, basing version probability and validation on industry adventure and on a variety of real-world examples, with a excessive point of aspect and detailed operative indications.

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Understanding and Managing Model Risk: A Practical Guide for Quants, Traders and Validators (The Wiley Finance Series)

A advisor to the validation and possibility administration of quantitative types used for pricing and hedgingWhereas nearly all of quantitative finance books specialise in arithmetic and threat administration books specialise in regulatory elements, this ebook addresses the weather ignored through this literature--the dangers of the types themselves.

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Example text

In fact the Russian default/restructuring was announced on 17 August 1998. , whose first version appeared in January 1999. This is after the Russian crisis. The same paper pictures the situation as it was at that time: ‘extensive conversations with numerous brokers and dealers indicate that most Wall Street firms use some form of a single-factor Black-Derman-Toy model in valuing their swaption positions and making exercise decisions. For example, the Black-Derman-Toy model is the default valuation model for American-style swaptions in the widely-used Bloomberg system’.

In the long term . . the apparent arbitrage opportunity detectable before the crisis has been revealed to be no such thing. But in the short/medium term, many of the valuations made by the market appeared very far from a rational reality of fundamentals for excess of optimism. And later, someone has argued that immediately after the crisis burst the quotes were far from the reality of fundamentals for excess of pessimism. In the end, the no-arbitrage principle seems to have been confirmed over the long term, and banks appear to believe in it by continuously trading in derivatives and hedging them with the underlyings: the practice of hedging, and even the name ‘derivative’ securities, would be meaningless lacking no-arbitrage, which is in the end just the principle of consistency between different securities.

It is interesting to recall also the most relevant example related to the aftermath of the Russian crisis. We follow again Rebonato (2002) who notices, ‘the Russia default and the nearcollapse of LTCM in 1998 brought about unprecedented dislocations in several markets. The interest rate volatility surfaces were not immune from these upheavals’. The events illustrated dramatically how unrealistic a deterministic volatility model can be, and the smile made a clear appearance in the interest rates market.

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