A new approach to assessing model risk in high dimensions

Abstract

Abstract A central problem for regulators and risk managers concerns the risk assessment of an aggregate portfolio defined as the sum of d individual dependent risks X i . This problem is mainly a numerical issue once the joint distribution of X 1 , X 2 , … , X d is fully specified. Unfortunately, while the marginal distributions of the risks X i are often known, their interaction (dependence) is usually either unknown or only partially known, implying that any risk assessment of the portfolio is subject to model uncertainty. Previous academic research has focused on the maximum and minimum possible values of a given risk measure of the portfolio when only the marginal distributions are known. This approach leads to wide bounds, as all information on the dependence is ignored. In this paper, we integrate, in a natural way, available information on the multivariate dependence. We make use of the Rearrangement Algorithm (RA) of Embrechts et al. (2013) to provide bounds for the risk measure at hand. We observe that incorporating the information of a well-fitted multivariate model may, or may not, lead to much tighter bounds, a feature that also depends on the risk measure used. In particular, the risk of underestimating the Value-at-Risk at a very high confidence level (as used in Basel II) is typically significant, even if one knows the multivariate distribution almost completely. Our results make it possible to determine which risk measures can benefit from adding dependence information (i.e., leading to narrower bounds when used to assess portfolio risk) and, hence, to identify those situations for which it would be meaningful to develop accurate multivariate models.