Trading models: New model army on the march
It seems astonishing that misuse of models still takes place in the foreign exchange market. But there is no doubt it does, although the industry’s self-imposed code of Omertà means that even those cases that seemingly everyone knows about rarely get exposed.
In theory, a poor model should be quickly discovered and either eliminated or tweaked so that it delivers more accurate prices. However, for various reasons, including intellectual arrogance and in some cases a crooked desire to book fictitious profits, this does not always occur.
A recent report entitled Model validation best practices: Achieving value-added from research consultancy Celent, now part of the Oliver Wyman group, suggests the implementation of a framework that will help ensure models perform as they should and actually add, rather than subtract, value. Authors Umit Kaya and Il-Dong Kwon point out that "the upsurge in usage of models, sophistication of underlying theories, and complexity of the IT environment have firmly placed model risk on regulator and senior executive agendas. Building a model governance framework to contain this risk has become a prevalent risk management practice. Model validation, essentially a peer review system with the ultimate goal of providing efficient quality control, has been an integral part of this effort."
They add: "Accounting troubles and tight regulatory controls around risk measurement models led the first model validation wave, primarily as a compliance exercise. The next wave will be characterized by repositioning beyond compliance towards a streamlined, value-adding model validation process.