Chapter 8: Model Risk

Question 1

what sort of risk is model risk and why does it occur primarily?

Answer 1

operational risk, occurs due to models having fundamental errors and the quality of data being inputted

Question 2

what are the benefits of modelling?

Answer 2

• simplified representations of the real-world relationships that exist between observed characteristics, values and events
• enables an unclear and complicated reality to be represented in a way that enables sound investment decisions to be made can be source of competitive

Question 3

what are the limitations of modelling?

Answer 3

• they may be too simple so any attempt to reuse their outputs for purposes other than that may have adverse consequences
• tendency to focus on the maximum loss at less than the 100% confidence level

Question 4

what are the limiting assumptions used when building models?

Answer 4

• shape of the underlying distribution used by the model
• relationship between the past and the future
• state of the business environment

Question 5

what are the major risk model used when looking at risk?

Answer 5

• operational risk scenario model
• Credit VaR
• Market VaR
• Liquidity at Risk

Question 6

what does operational risk scenario modelling involve?

Answer 6

risk workshops held with senior risk and business personnel to ensure goof quality model inputs are collected

Question 7

how is the level of capital necessary to cover potential scenarios obtained through operational risk modelling?

Answer 7

loss impacts and frequencies are subjected to modelled stress

Question 8

how are operational risk loss events presented in a model?

Answer 8

they are not ‘normally distributed’, follow a distribution that exhibits fat tail characteristics

Question 9

how does credit VaR work?

Answer 9

attempts to predict the value of a security in a period of time according to its probability of moving from one credit rating to another, credit migration is only a probability

Question 10

what is Market VaR used for?

Answer 10

widely used measure that expresses the maximum market loss that can occur with a specified confidence over a specified period of time, clear uncertainty about how much could actually be lost

Question 11

how is Market VaR found (steps)?

Answer 11

• identify risk factors
• select a sample of risk factor changes
• systematically apply each of those daily changes to the current value for each risk factor
• list out all of the resulting portfolio values

Question 12

what is LaR used for?

Answer 12

Liquidity at Risk, used to estimate the likelihood of liquidity shortages within a firm, uses maturity ladder. gives the firm an idea of its likely funding requirement over a given time period at different confidence levels

Question 13

what are the elements of a sound model risk governance framework?

Answer 13

• covers the roles and responsibilities of different parts of the organisation
• covers the use of policies and procedures

Question 14

what is the role of directors and senior management in effective governance of risk modelling?

Answer 14

• establishing model risk controls
• establishing adequate policies and procedures
• recognising potential need for the creation of provisions

should ensure that the level f model risk is within their risk appetite

Question 15

what external resources can be used for effective governance of risk modelling?

Answer 15

can help execute certain activities related to the model risk management framework, should be validated by an internal party

Question 16

how can policies and procedures help with effective risk modelling governance?

Answer 16

all aspects of risk management should be covered by the policies set out, should emphasise testing and analysis, promote development of targets for accuracy, should require maintenance as well (documents as well as the framework)