Lessons learned from AQR: Essential elements of the model review process

Abstract

This paper focuses on the steps performed during an external review of processes and methods related to the valuation of derivatives. The review covers the adequacy of the chosen models, and the models’ parameterisation and calibration, as well as implementation features, followed by a discussion of risk-mitigation and risk-monitoring techniques. We illustrate each step with practical examples. The purpose of such a review of derivative pricing models is to identify potential gaps in order to improve the existing modelling framework. The external review is not part of the regular model validation process, but relies largely on the available model validation documentation. Hence, the paper addresses primarily risk managers responsible for the embedding of the above-mentioned steps in the model validation documentation. Nevertheless, auditors and model reviewers might also be interested in the discussion of these review steps. Other organisational aspects (eg the allocation of responsibilities, escalation procedures, etc) are beyond the scope of this paper.