Toward model value-at-risk: bespoke CDO tranches, a case study

Abstract

In the aftermath of the subprime crisis the importance of model risk has come to be understood, leading regulators to ask for model risk measurement and management in financial institutions. On the other hand, in spite of recent advances, the subject still lacks a clear and widely accepted methodology as is the case for market or credit risk: although the methods in these fields are questioned and can be improved, there is, as far as practical issues are concerned, a wide acceptance of some guiding principles. This is not the case for model risk. We argue that the mainstream research has to be supplemented by new insights and methods when it comes, for example, to over-the-counter credit products. We propose, in particular, a new method, called model value-at-risk, that aims to answer such questions as, what is the model-dependent value-at-risk of an investment at one year at a confidence level of 95%? We have chosen the case study of bespoke collateralized debt obligation tranches, but most of our reasoning could be adapted to other complex contracts where market prices are not available and the choice of benchmark pricing method is subject to uncertainty: for example, mortgage-backed and residential mortgage-backed securities, collateralized loan obligations, leveraged buyouts and real options. These topics will be the subject of further research.