Journal of Computational Finance

Risk.net

A new approach to the quantification of model risk for practitioners

Zuzana Krajčovičová, Pedro Pablo Pérez-Velasco and Carlos Vázquez

  • A new general framework for the quantification of model risk is proposed.
  • Tools from differential geometry and information theory are considered.
  • Quantification of model risk in terms of the norm of an appropriate function in a Riemann manifold of models endowed with FisherRao metric.
  • Application to a credit risk model for capital calculation.
  • Potential extension to quantify model risk in a variety of financial modeling approaches.

Global regulation obliges financial institutions to manage model risk with the same severity as any other risk. Its quantification is therefore essential to meet these requirements and to ensure an institution’s basic internal operations are able to run smoothly. In this paper, we address the quantification of model risk by calculating the norm of an appropriate function defined on a Riemannian manifold endowed with a Fisher–Rao metric. Our aim is twofold: to introduce a mathematical framework that is sufficiently general and sound to cover the main areas of model risk, and to illustrate how a practitioner can identify the relevant abstract concepts and put them to work.

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