Darwinian model risk and reverse stress testing
Abstract
We consider the risk of adverse model selection, whereby a trader selects a model leading to superiorly competitive prices, the ensuing valuation loss for the bank being more than offset by gains on the hedging side of the position. But this is only the case until a stress event reveals the erroneous nature of the model used, forcing the bank to liquidate the position and its hedge at the cost of heavy losses. This "Darwinian model risk" is directional (related to a long-term moment of order one of the PnL) and likely to stay unnoticed from traditional risk systems, which are focused on shorter-term moments of order two and beyond. One possible approach to detect it consists of long-term, large-scale simulations, revealing the consequences of using various models in extreme scenarios. Based on: 1) Claudio Albanese, Stéphane Crépey, and Stefano Iabichino (2021). A Darwinian theory of model risk. Risk Magazine July pages 72-77. 2) Claudio Albanese, Stéphane Crépey, and Stefano Iabichino (2021). Reverse Stress Testing. ssrn.3544866
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