Which of the following are examples of model risk illustrated in the Long-Term Capital Management case?
I. Poor management oversight. II. Financial reporting standards. III. Ignoring autocorrelation of economic shocks. IV. Underestimating correlations among asset classes during economic crises.
A. II, III, and IV only. B. I, II, III, and IV. C. III and IV only. D. I only.
LTCM’s models underestimated the extent to which securities prices would move together in times of economic crisis. The models also failed to anticipate that multiple economic shocks might occur in clusters through time (i.e., be positively autocorrelated) as economic history suggests. Poor management oversight and financial reporting standards are not issues in the LTCM case.
