We propose a procedure to take model risk into account in the computation of capital
reserves. This addresses the need to make the allocation of capital reserves to positions
in given markets dependent on the extent to which reliable models are available. The
proposed procedure can be used in combination with any of the standard risk measures,
such as value-at-risk and expected shortfall.
We assume that models are obtained by usual econometric methods, which allows
us to distinguish between estimation risk and misspecification risk. We discuss an additional
source of risk which we refer to as identification risk. By way of illustration, we
carry out calculations for equity and FX data sets. In both markets, estimation risk and
misspecification risk together explain about half of the multiplication factors employed
by the Bank for International Settlements (BIS).

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VaR Methods——Evaluation/Comparison