Podcast: Claudio Albanese on how bad models survive

At almost every financial firm, there will be some models that are unfit for purpose. But how do flawed models manage to exist for so long?

Claudio Albanese, founder and head of development at Global Valuation – and our guest for this episode of Quantcast – thinks Darwin’s theory of evolution may offer some insight into that question. 

For his latest study, Albanese, together with Stéphane Crépey at Université de Paris and Stefano Iabichino of JP Morgan, adapted Darwin’s principles to show how low-quality models that overvalue and overhedge structured products can survive – and even thrive – in the short term.

Because traders can sometimes profit by overhedging certain derivatives structures, they may be incentivised to overlook the weaknesses of particular models. The trade-off is that they will end up taking long-term risks that are unaccounted for by the models, potentially leading to painful losses.

As an example, Albanese and his co-authors show the effect of using low-quality models to price range accruals – an exotic structured product with a fraught history. But their findings are relevant to other derivatives too – in particular, those with embedded callability.  

Albanese argues a Darwinian lens may help banks detect bad models and inefficient hedging strategies – and avoid the dangerous exposures they create.

This foray into model risk is a departure for Albanese, who is known for his contributions to the study of derivatives valuation adjustments. On that topic, he shares his thoughts on the concept of a hedging valuation adjustment, which was recently introduced by Ben Burnett at Barclays and calls for it to be expanded beyond transaction costs.

That might be a subject for another podcast.

Index

00:00 Intro

02:50 Motivation for the model risk study

05:25 Range accruals case study

09:30 The risk of overhedging

13:10 Visualising model risk as it materialises

17:15 The connection between natural selection and derivatives models

21:15 What products are potentially affected by flawed pricing models?

25:00 Future research

To hear the full interview, listen in the player above, or download. Future podcasts in our Quantcast series will be uploaded to Risk.net. You can also visit the main page here to access all tracks, or go to the iTunes store or Google Podcasts to listen and subscribe.