Model Risk and Regulatory Capital

54 Pages Posted: 24 Feb 2002

See all articles by Jeroen Kerkhof

Jeroen Kerkhof

Lehman Brothers International, Europe

Johannes M. Schumacher

University of Amsterdam - Department of Quantitative Economics (KE)

Bertrand Melenberg

Tilburg University - Center for Economic Research (CentER)

Date Written: February 22, 2002

Abstract

In this paper we propose a general framework for quantification of model risk. This framework allows us 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 typically much more important than estimation risk.

Keywords: Model risk, Capital requirements, (Coherent) risk measurement, Derivative pricing models

JEL Classification: G12, G18

Suggested Citation

Kerkhof, F.L. Jeroen and Schumacher, J.M. (Hans) and Melenberg, Bertrand, Model Risk and Regulatory Capital (February 22, 2002). Available at SSRN: https://ssrn.com/abstract=301531 or http://dx.doi.org/10.2139/ssrn.301531

F.L. Jeroen Kerkhof (Contact Author)

Lehman Brothers International, Europe ( email )

25 Bank Street
30th Floor
London E14 5LE
United Kingdom

J.M. (Hans) Schumacher

University of Amsterdam - Department of Quantitative Economics (KE) ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands

Bertrand Melenberg

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2730 (Phone)

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