A financial institution may use different models for different purposes. Analytical
tractability, ease of understanding, and simplicity in monitoring transactions can
favour the use of distinct models for separate tasks. However, mixing or aggregating
the results of different models is risky. For instance, with respect to market prices,
an asset might appear as overvalued using one model and undervalued using an
alternative one. In such a case, the two arbitrage opportunities are just modelinduced
illusions.
The problem of model risk in the aggregation process is crucial for derivatives,
which are often decomposed into a set of simpler building blocks for pricing or
hedging purposes. The pieces together may not behave as the combined whole, as
was shown by some recent losses in the interest rates derivatives and the mortgage
back securities sectors.
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