Risk Management Models: Construction, Testing, Usage

Financial risk management models are alleged to have helped cause the 2007 credit crisis. There is some truth to these concerns. Risk management models were used wrongly prior the crisis, and they are still being misused today. This article critically analyzes risk management models construction, testing, and usage. In the process., we show that there are two common misuses of these models associated with calibration and hedging "the greeks." In particular we show that: 1) vega hedging with a calibrated Black-Scholes option pricing model is a nonsensical procedure, 2) using the implied default probabilities from a structural credit risk model to price credit default swaps is erroneous, and 3) using the default correlations obtained from credit risk copula models for computing value-at-risk measures leads to misspecified estimates. We provide alternatives to these misuses and a road map for the proper usage of risk managment models.