A Pathwise Approach to Interest-rate Model Risk and Debt Management

Mark Reesor


Abstract

Model risk is an important consideration in all areas of finance including pricing, portfolio selection, and risk management.  We propose a path-wise method for assessing interest-rate model risk in a simulation environment.  The particular application we focus on is debt management, a task faced by many governments and institutions who raise funds by selling bonds.  With a simple example we show that the interest-rate model has a significant effect on the measures of cost and risk associated with a debt portfolio strategy.  When considering a variety of term-structure models, our proposed path-wise approach to model risk leads to conservative bounds on measures of cost and risk which, in turn, can help to identify robust portfolio strategies.