Model risk and techniques for controlling market parameters

The increasing use of internal market models for market risk assessment andmanagement promotes, in compliance with Basel II, better risk managementpractices but introduces at the same time the so called model risk. In the light of themany open issues connected to market risk, the aim of this paper is twofold. First, itoffers a formal analysis of model risk which is aimed to clarify quantification issuesand to illustrate the architecture of a control process for this type of risk. Animportant building block of such an architecture is the so called market parameterscontrol process, which is the focus of the present paper and consists of two differentphases: the definition of the data sources and the data retrieval forms, and thedefinition of the techniques for valuing variables (i.e. input model data) based onmarket data. Second, this paper proposes a market parameters control process and its implementation within an important Italian bank, namely Gruppo Banco Popolare.Specifically, by focusing on equity market risk, this paper illustrates the whole organization process needed to set up and implement the market parameters control techniques, which imply first controlling for integrity (existence, domain, homogeneity) and outliers and then performing benchmarking activities. Special emphasis is placed on the so-called second level parameters, which do not have official quotes and still are fundamental especially in valuing non linear positions (e.g. volatility). These activities are based on mathematical-statistical models, whose implementation has required the development of specific software and IT solutions and the adoption of an articulate organizational structure.