Claudio Albanese - Model Risk and Reverse Stress Testing

Webinar
Wednesday, April 8, 2020 - 06:30 PM
Until: Wednesday, April 8, 2020 - 08:30 PM
(Adjusted for timezone: Europe/London)
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PLEASE NOTE THAT THIS WEBINAR WILL START ON WEDNESDAY, 8 APRIL, 2020, AT 6:30pm ***LONDON TIME***

TITLE: Model Risk and Reverse Stress Testing

ABSTRACT:

The presentation covers two articles exploring the connections and interplay between model risk and stress testing. Based on the same Champion and Challenger pair of models, the two articles discuss the cases of callable range accruals in the USD and the case of CVA/FVA metrics for a fixed income derivative portfolio in G10 currencies.

Both articles are based on long-run, forward looking methods and the same universal solver is used overall. In the case of range accruals, we find that 3d animations are useful to visualise model risk and hedging strategies. In the case of XVA metrics, we use nested Monte Carlo simulations to identify stress scenarios based on specific contributions to cost of capital.

We suggest that a pricing model is invalid if it breaks down on a path leading to stress conditions. Frequent model recalibrations generate a drift term in the Doob-Meyer decomposition, similar to an alpha term in CAPM, which goes entirely undetected by VaR/ES/StressVar market risk metrics and is arguably responsible for the largest ever observed losses in derivative markets. We also suggest that trading limits are best assessed by a cost-of-capital model and that model risk capital (for valid models) can be quantified by means of Bayesian averages.

BIOGRAPHY

Claudio Albanese studied Physics at ETH Zurich and was junior faculty in Princeton and NYU before joining the University of Toronto in 1994 where he changed academic path as he founded a master level program in Mathematical Finance. Claudio then held a Chaired Professorship in Math Finance at Imperial College London before moving to the private sector where he has been running a boutique software firm since 2006. In the past 15 years, he focused on the development of tensor methods for risk and pricing analytics. As side research projects, he published on valuation adjustments, hedging, model risk and stress testing.

LINKS TO PAPERS AND ANIMATIONS

Albanese, Claudio and Crepey, Stephane and Iabichino, Stefano, A Darwinian Theory of Model Risk (February 26, 2020). Available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3544862

Albanese, Claudio and Crepey, Stephane and Iabichino, Stefano, Reverse Stress Testing (February 26, 2020). Available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3544866

Animations: https://www.youtube.com/watch?v=CVVbcEfaEBU

For more information, visit https://www.meetup.com/thalesians/events/269831570/. Event link visible to attendees.
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