The Evaluation of Model Risk for Probability of Default and Expected Loss

The quanti�cation of model risk is still in its infancy. This paper provides an operational quanti�cation of this risk for credit portfolio, when the objective is to approximate the average loss. The methodology is easy to implement and does not require the construction of any worst-case model. The required capital computed to cover for model risk depends on three components, that are an estimated impact of the incorrect model, an evaluated risk of inaccurate estimation of model risk and the prediction error hedge factor. The approach is illustrated by an application to a portfolio of corporate loans segmented by grades.