Quantifying Distributional Model Risk via Optimal Transport

Abstract

This paper deals with the problem of quantifying the impact of model misspecification when computing general expected values of interest. The methodology that we propose is applicable in great generality; in particular, we provide examples involving path-dependent expectations of stochastic processes. Our approach consists of computing bounds for the expectation of interest regardless of the probability measure used, as long as the measure lies within a prescribed tolerance measured in terms of a flexible class of distances from a suitable baseline model. These distances, based on optimal transportation between probability measures, include Wasserstein’s distances as particular cases. The proposed methodology is well suited for risk analysis and distributionally robust optimization, as we demonstrate with applications. We also discuss how to estimate the tolerance region nonparametrically using Skorokhod-type embeddings in some of these applications.