Derivative Pricing Model Review: Key Steps and Best Practices from the ECB's Asset Quality Review
In November 2014, the ECB launched the Single Supervisory Mechanism (SSM) and conducted a comprehensive assessment of significant European banks. As part of this Asset Quality Review (AQR), derivative pricing models underwent rigorous external review. This paper by Beinker et al. distils the essential steps of that model review process, offering a practical guide for risk managers, auditors, and model validators.
The paper structures the review into three core areas:
Model adequacy and implementation — assessing whether the chosen model captures the material risk factors (e.g. asset dynamics, volatility smile, correlation dependencies) and whether the numerical implementation (Monte Carlo, analytical solutions) is correct and efficient. Practical examples include exotic equity options (local vs. stochastic volatility) and CMS spread options (multi-factor interest rate modelling).
Model parameterisation and calibration — reviewing the selection of liquid market data, quoting conventions, smoothing algorithms, use of proxies for illiquid instruments, and estimation of unobservable parameters such as correlations. The stability and convexity of the calibration procedure are also examined.
Reserves against model deficiencies — quantifying reserves for model risk (e.g. via periodic comparison with third-party models), parameter uncertainty (e.g. correlation variance), and numerical errors. Individual reserves are aggregated using a square-root-of-sum-of-squares approach under an independence assumption.
The key takeaway is that embedding these review analyses into existing model validation documentation — ideally as early as possible in the model lifecycle — significantly facilitates future audits and improves the overall modelling framework. Enforcing such considerations within the model validation policy demonstrates a bank's deep understanding of derivative modelling and the associated model risk.