Model Risk in Credit Risk

Abstract: The issue of model risk in default modeling has been known since inception of the Academic literature in the field. However, a rigorous treatment requires a description of all the possible models, and a measure of the distance between a single model and the alternatives, consistent with the applications. This is the purpose of the current paper. We first analytically describe all possible joint models for default, in the class of finite sequences of exchangeable Bernoulli random variables. We then measure how the model risk of choosing or calibrating one of them affects the portfolio loss from default, using two popular and economically sensible metrics, Value-at-Risk (VaR) and Expected Shortfall (ES).