Market and Model Risk: Sequentially Interweaved Risk Dimensions

Market risk is the potential for losses in securities due to fluctuations in market factors like interest rates, currency values, FX/commodity spot rates, and equity prices. These risks are inherent in all traded securities, from corporate bonds to commodities. Each type of security may face multiple risks simultaneously, making market risk a crucial consideration for investors and financial institutions.

Compounding these risks is model risk, which refers to the risk inherent with the development and usage of a model to determine financial outputs and decision making. An inefficient or incorrect modelling technique can sometimes lead to drastic repercussions for the firm. Understanding and managing this risk is therefore essential for making informed financial decisions and safeguarding against potential losses.

More on Market Risk

Various risk factors in the security’s structure determine the type and extent of the market risk it carries. The most widely studied and observed market risk types include interest rate risk, credit risk, foreign exchange risk, equity risk, and commodity risk. A single security can exhibit just one or more of these risks. A corporate bond, for example, exhibits not just credit risk but also interest rate risk, and if it is denominated in a foreign currency, it also carries FX risk. Broadly, we can think of market risk as the fluctuation in the value of a security due to the market-related risk factors such as interest rates and equity price movements. However, it has far-reaching impacts since these security valuations are utilized to make more decisions such as investments, regulatory compliance, and portfolio optimization, among others, depending on the profile of the company or risk manager.

More on Model Risk

A model has various components, namely the inputs/data, assumptions, logic/process, and final output. An inefficient or incorrect modelling technique along any of these process components can sometimes lead to drastic repercussions for the firm. The SR11-7 regulatory framework defines how model risk should be managed by banks, and it is relevant for other financial firms.

Market Risk and Model Risk: Dependencies

Although market and model risk represent different dimensions of riskiness, they are interweaved in a sequential way. This is evident since quantification or determination of market risk by a firm and all resulting decisions are usually represented as an output of financial models. Whenever corporate managers are focused on managing market risk proficiently, the process involves managing model risk equally efficiently. Thus, it makes sense to view these two risks in conjunction with each other when estimating costs, time, and resources to manage a firm’s investment -or market-related risks.

An example would be the use of a financial model to determine the value of a securities portfolio which in turn would determine a buy/sell decision. If the valuation model makes incorrect assumptions by not considering diversification/hedging effects in the portfolio, this might lead to incorrect decision making which may lead to not just financial impact for the firm but also reputational and regulatory risks.

Model risk is a crucial risk that needs to be managed effectively by financial institutions, not just to ensure sound market risk management decisions or comply with regulatory requirements but also to survive and thrive. In cases in which firms use third-party vendors for pricing and valuations, model risk is compounded because most vendors also use models to determine their numbers. In such cases, clients must conduct due diligence to ensure third-party vendor models are validated and/or audited.

Regulatory Use Case

The Fundamental Review of Trading Book (FRTB) is a market risk regulatory framework with a lot of quantitative techniques enlisted by the regulator to quantify market risk carried on banks’ trading books in the form of capital charges. One crucial change in this regulatory framework is a shift from existing value at risk (VaR) based techniques to expected shortfall-based market risk metrics calculations. This shift requires modifying existing market risk models or in some cases rebuilding these from scratch to efficiently carry out these FRTB customized calculations. This gives rise to a wide amount of model-related risk from new assumptions, input data, modifying codes/software programs, and output metric customization. If FRTB model assumptions are changed, the capital charge numbers may vary considerably. Application of this framework to manage market risk more efficiently introduces extra costs and complexities to manage model risk inherent in new or updated custom models to carry out these FRTB specific calculations.

Key Takeaway

Risk managers must look at market and model risk through a single lens to see the complete picture of their market-related investment and trading risks, as well as management costs, complexities, time, and regulatory requirements.

References