What does Model Risk mean? Can you please explain and with a relevant example applicable to Level 3?
Suppose that you’re considering buying a callable bond. You calculate the bond’s OAS using a binomial tree with 10% interest rate volatility. The OAS you calculate is 202 bps, which is high enough, so you buy the bond.
One year later, you discover that the actual interest rate volatility has been 30%, not 10%. If you had used 30% in your model, you would not have bought the bond as the OAS you calculated would have been 85 bps, lower than your threshold.
By the way, the bond gets called in one year and you learn that you earned a spread of 87 bps.
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