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INVESTMENTPROCESSINDYNAMICFRAMEWORK…
Riskmodels
Themaingoalofthisgroupistospecifythemodelwhichdetermineslevel
ofriskoffinancialinstrument.Thismodelhelpstomakedecisionstomanage
thisrisk.Themostcommontypesofriskhandledbythesemodelsare:
–marketrisk–riskresultingfromthechangesofpricesinthefinancialmarket
(interestraterisk,exchangeraterisk,stockpricerisk,commoditypricerisk).
–creditrisk–riskresultingfromthepossibilitythatthecounterpartywillnot
makecontractualpayments.
Thedescribedmodelsusedininvestmentmanagementareonlyapproxi-
mations.Therefore,applicationoffinancialmodelraisestheissueofincorrect
descriptionofrealworld(financialmarket),whatcanleadtowrongdecisions.
Thisiscalledmodelrisk.
Thenotion“modelrisk”canbedefinedinthegeneralandsimplifiedway:
Modelriskisariskresultingfromerraticmodelusedinrealworld.
VerygoodcommonsenseexplanationofmodelriskisgivenbyRobert
Merton.Hestated[7],that:„Attimeswecanlosesightoftheultimatepurpose
ofthemodelswhentheirmathematicsbecomestoointeresting.Themathe-
maticsoffinancialmodelscanbeappliedprecisely,butthemodelsarenotall
preciseintheirapplicationtothecomplexrealworld.Theiraccuracyasauseful
approximationtothatworldvariessignificantlyacrosstimeandplace.Themo-
delsshouldbeappliedinpracticeonlytentatively,withcarefulassessment
oftheirlimitationsineachapplication”.
Thereareatleastthreedistinctsourcesofuncertaintyresultinginmodel
risk(eachofthemcanbeillustratedbylooking,forexample,atoptionpricing
model):
1.Uncertaintyastothestructureofthemodel.
Thisrefers,forexample,tothesituationinwhichsomeimportantfactors
(variables)areomitted;thereiswrongfunctionalformofrelationshipbetween
thevariablesinthemodel,etc.Goodexamplecouldbeoptionpricingmodel
ofalinearform.Fortunately,suchmodelisnolongerproposedinfinancial
literatureandnotusedinrealapplications.
2.Uncertaintyastotheparametersofthemodel.
Evenifthereiscorrectstructureofthemodel,someparametersofthe
modelusuallyneedtobeestimated.Modelriskoccurs,sincetherearedifferent
estimationmethods,possibilitiesofusingdifferentdatasets,etc.Theexample
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