Learning objectives: Explain methods and procedures risk managers can use to mitigate model risk. Explain the impact of model risk and poor risk governance in the 2012 London Whale trading loss and the 1998 collapse of Long Term Capital Management (LTCM).
Questions:
605.1. In response to the question, "How Can We Mitigate Model Risk?" Crouhy, Galai & Mark offer this advice: "One important way to mitigate model risk is to invest in research to improve models and to develop better statistical tools, either internally at the bank or externally at a university (or at an analytically oriented consulting organization). An even more vital way of reducing model risk is to establish a process for the independent vetting of how models are both selected and constructed. This should be complemented by independent oversight of the profit and loss (P& L) calculation."
Each of the following is true about the phases of this model vetting EXCEPT which is false?
a. The vetting team should ask for full documentation of the model
b. The middle office must have independent access to an independent market risk management financial rates database
c. The benchmark model should have the same implementation as the proposed model, but it should have different parameters
d. The model must be stressed tested, including looking at limit scenario(s) in order to identify the range of parameter values for which the model is accurate
605.2. According to Crouhy et al, "The failure of the hedge fund Long Term Capital Management (LTCM) in September 1998 provides the classic example of model risk in the financial industry. " Each of the following is true about the collapse of Long Term Capital Management EXCEPT which is false?
a. Before the collapse, their relative-value and market-neutral strategies were viewed by lenders as relatively safe ("low-risk") despite the high leverage (debt-to-equity of 25)
b. LTCM should have raised red flags due to blatant governance problems including a board that lacked economic credentials and executives without seasoning and actual fixed income trading experience
c. The "flight to quality" triggered by the Russian default abruptly decoupled the historical patterns of spread convergence (between safe and risky bonds) and the previously negative correlation between stock returns and interest rates
d. Weakness of LTCM's value at risk (VaR) model included: 10 days was too short a time horizon; liquidity risk was not sufficiently modeled as a factor; and stress testing was insufficient especially with respect to correlation and volatility risks
605.3. According to Crouhy, Galai & Mark, which of the following statements about model risk is TRUE?
a. Finance requires the use of models and models necessarily imply model risk, therefore model risk is inevitable
b. Model risk is unique because it is predominantly the manifestation of a technical issue: given sufficient and qualified quantitative and and programing expertise, model risk should be virtually eliminated in a firm
c. The "Tinkerbell phenomenon" refers to a model which is too small in its capability, so to speak; for example, the model can only accommodate a certain range of inputs so it cannot realistically model the full range of financial transactions
d. Given identical confidence levels and time horizons for value at risk (VaR) and expected shortfall (ES), research demonstrates that different third-party vendors and different groups within an institution will generate "remarkably similar" VaR and ES estimates
Answers here:
Questions:
605.1. In response to the question, "How Can We Mitigate Model Risk?" Crouhy, Galai & Mark offer this advice: "One important way to mitigate model risk is to invest in research to improve models and to develop better statistical tools, either internally at the bank or externally at a university (or at an analytically oriented consulting organization). An even more vital way of reducing model risk is to establish a process for the independent vetting of how models are both selected and constructed. This should be complemented by independent oversight of the profit and loss (P& L) calculation."
Each of the following is true about the phases of this model vetting EXCEPT which is false?
a. The vetting team should ask for full documentation of the model
b. The middle office must have independent access to an independent market risk management financial rates database
c. The benchmark model should have the same implementation as the proposed model, but it should have different parameters
d. The model must be stressed tested, including looking at limit scenario(s) in order to identify the range of parameter values for which the model is accurate
605.2. According to Crouhy et al, "The failure of the hedge fund Long Term Capital Management (LTCM) in September 1998 provides the classic example of model risk in the financial industry. " Each of the following is true about the collapse of Long Term Capital Management EXCEPT which is false?
a. Before the collapse, their relative-value and market-neutral strategies were viewed by lenders as relatively safe ("low-risk") despite the high leverage (debt-to-equity of 25)
b. LTCM should have raised red flags due to blatant governance problems including a board that lacked economic credentials and executives without seasoning and actual fixed income trading experience
c. The "flight to quality" triggered by the Russian default abruptly decoupled the historical patterns of spread convergence (between safe and risky bonds) and the previously negative correlation between stock returns and interest rates
d. Weakness of LTCM's value at risk (VaR) model included: 10 days was too short a time horizon; liquidity risk was not sufficiently modeled as a factor; and stress testing was insufficient especially with respect to correlation and volatility risks
605.3. According to Crouhy, Galai & Mark, which of the following statements about model risk is TRUE?
a. Finance requires the use of models and models necessarily imply model risk, therefore model risk is inevitable
b. Model risk is unique because it is predominantly the manifestation of a technical issue: given sufficient and qualified quantitative and and programing expertise, model risk should be virtually eliminated in a firm
c. The "Tinkerbell phenomenon" refers to a model which is too small in its capability, so to speak; for example, the model can only accommodate a certain range of inputs so it cannot realistically model the full range of financial transactions
d. Given identical confidence levels and time horizons for value at risk (VaR) and expected shortfall (ES), research demonstrates that different third-party vendors and different groups within an institution will generate "remarkably similar" VaR and ES estimates
Answers here:
