Risk-Adjusted Performance Measurement under Model Risk

Model risk, i.e the risk that a model used to evaluate a financial product may prove to be inadequate either to price the product correctly or to model its dynamics as market risk factor change, has been usually studied for its consequences on pricing and hedging of financial instruments. The chapter is devoted instead to point out its consequences on risk-adjusted performance measurement, showing that model risk may potentially lead to overestimating the profitability of business units which are most exposed to model risk. The chapter discusses the potential consequences on capital allocation and the ways in which the effects of model risk may be limited in the profitability reports of the different business units.