LO 47.3: Explain methods and procedures risk managers can use to mitigate model

LO 47.3: Explain methods and procedures risk managers can use to mitigate model risk.
Model risk can be mitigated either through investing in research to improve the model or through an independent vetting process. Investing in research leads to developing better and more accurate statistical tools, both internally and externally. Independent vetting includes the independent oversight of profit and loss calculations as well as the model selection and construction process. Vetting consists of the following six phases: 1. Documentation. Documentation should contain the assumptions of the underlying
model and include the mathematical formulas used in the model. It should contain a term sheet to describe the transaction, a mathematical statement of the model (all the variables and processes, payoff function and pricing algorithms, calibrations, and hedge ratios and sensitivities), and the implementation features, including inputs, outputs, and any numerical methods.
2018 Kaplan, Inc.
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Topic 47 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 15
2. M odel soundness. Vetting should ensure that the model used is appropriate for the
financial instrument being valued. For example, a model valuing option-free bonds would not be appropriate to value convertible or callable bonds.
Independent access to rates. To facilitate independent parameter estimation, the model vetter should ensure that the middle office has access to independent financial rates.
4. Benchmark selection. The vetting process should include selecting the appropriate
benchmark based on assumptions made. Results from the benchmark test should be compared with the results from the model test.
3. Health check and stress test. Models should be vetted to ensure they contain all necessary properties and parameters. Models should also be stress tested to determine the range of values for which the model provides accurate pricing.
Incorporate model risk into the risk management framework. Model risk should be considered in the formal risk management governance and framework of an institution. In addition, models need to be periodically reevaluated for relevance and accuracy. Empirical evidence suggests that simple, robust models work better than more complex and less robust models.
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