How well do interest rate risk models perform?
When making decisions under uncertainty we typically want to know how well our model of the world has performed in the past and if it would help us to make better decisions in the future. We therefore want to review how our models have performed in reality and till what extend they can really help us in the decision making process.
Following the financial crisis in the beginning of the century, there has been an increase in the global public effort to develop frameworks that help financial institutions to estimate and manage risk. The primary focus is on setting rules for the determination of capital needed to cover for possible losses caused by extreme changes in factors such as interest, inflation, and equity.
Basel models, for instance, refer to a set of regulations for buffer estimation within the banking sector. Solvency II models, on the other hand, aim at achieving the same for the insurance sector in Europe. The development of local regulations such as Wtp in The Netherlands is specifically targeted at the pension fund industry.
Following those developments, many organisations in the financial service sector started to use such models as a reference for their external and internal risk reporting. This raises the question:
How do these models perform?
In this series of articles we will focus on the performance of the following interest rate risk models: