ModelRiskChapter 22RiskManagementandFinanciallnstitutions3e,Chapter22,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 22, Copyright © John C. Hull 2012 Model Risk Chapter 22 1
Marking the Prices of anInstrument to Market. Use price quoted by market maker(usually financial institutions mark to midof bid and offer) Use price at which financial institution hastraded productUse interdealerbrokerprices Use interdealerprice indications Use model (marking to model2RiskManagementandFinancialInstitutions3e,Chapter22,CopyrightJohnC.Hull2012
Marking the Prices of an Instrument to Market ⚫ Use price quoted by market maker (usually financial institutions mark to mid of bid and offer) ⚫ Use price at which financial institution has traded product ⚫ Use interdealer broker prices ⚫ Use interdealer price indications ⚫ Use model (marking to model) Risk Management and Financial Institutions 3e, Chapter 22, Copyright © John C. Hull 2012 2
AccountingFASB 157 and IASB 39 classify instruments as"held for sale" or “held to maturityThose classified as held for sale have to bemarked to marketLevel 1: uses quoted prices in active marketsLevel 2: uses quoted prices for similar product inactive markets or same product in non-active marketsLevel 3:requires valuation assumptions3RiskManagementandFinancialInstitutions3e,Chapter22,CopyrightJohnC.Hull2012
Accounting ⚫ FASB 157 and IASB 39 classify instruments as “held for sale” or “held to maturity” ⚫ Those classified as held for sale have to be marked to market ⚫ Level 1: uses quoted prices in active markets ⚫ Level 2: uses quoted prices for similar product in active markets or same product in non-active markets ⚫ Level 3: requires valuation assumptions Risk Management and Financial Institutions 3e, Chapter 22, Copyright © John C. Hull 2012 3
Controversial Changes in 2008and2009Banks can in rare circumstances reclassifyinstruments from "held for sale" to "held tomaturity" and vice versaBanks can use model prices in preferenceto market prices when they judge marketprices do not represent fair valueRiskManagementandFinancialInstitutions3e,Chapter22,CopyrightJohnC.Hull20124
Controversial Changes in 2008 and 2009 ⚫ Banks can in rare circumstances reclassify instruments from “held for sale” to “held to maturity” and vice versa ⚫ Banks can use model prices in preference to market prices when they judge market prices do not represent fair value Risk Management and Financial Institutions 3e, Chapter 22, Copyright © John C. Hull 2012 4
Model Risk Can Lead To..Incorrect price at time product is bought orsoldIncorrect hedging5RiskManagementandFinancialInstitutions3e,Chapter22,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 22, Copyright © John C. Hull 2012 Model Risk Can Lead To. ⚫ Incorrect price at time product is bought or sold ⚫ Incorrect hedging 5