Model Risk : Lessons from Past Catastrophes

Financial engineers should study past crises and model breakdowns rather than simply extrapolate from recent successes. The first part of this chapter reviews the 2008 disaster in convertible bonds and convertible arbitrage. Next, activity in nineteenth century option markets is examined to explore the importance of modern theory in pricing derivatives. The final section reviews the linkage between theory and practice in bridge building. The particularly interesting analogy is the constructive direction taken by engineers after the highly visible, catastrophic failure of the Tacoma Narrows Bridge in 1940. Engineers were reminded that highly realistic models may increase the likelihood of failure if they reduce the buffer against factors ignored by the model. Afterward, they focused efforts on making bridges robust enough to withstand eventualities they did not fully understand and could not forecast with accuracy