ABSTRACT:

Simulation methodology has traditionally focused on measuring and reducing sampling error in simulating well-specified models; it has given less attention to quantifying the effect of model error or model uncertainty. But simulation actually lends itself well to bounding this sort of model risk. In particular, if the set of alternative models consists of all models within a certain “distance” of a baseline model, then the potential effect of model risk can be estimated at low cost within a simulation of the baseline model. I will illustrate this approach to making Monte Carlo robust with examples from finance, where concerns about model risk have received heightened attention. The problem of bounding “wrong-way risk” in counterparty risk presents a related question in which model uncertainty is limited to the nature of the dependence between two otherwise certain marginal models for market and credit risk. The effect of uncertain dependence can be bounded through convenient combinations of simulation with linear programming and/or convex optimization. This talk is based on work with Xingbo Xu and Linan Yang.