Xuping Zhang Director, Model Validation, Global Model Risk Management Scotiabank, Canada

1. Managing valuation model risk with sound validation and approval framework 6th Annual Pricing Model Validation September 9 – 11, 2013 Xuping Zhang Director, Model Validation, Global Model Risk Management Scotiabank, Canada

2. Disclaimer The opinions and materials contained herein do not reflect the opinions and beliefs of the presenter’s employer.

3. Outline • Overview of valuation models used for different products and purposes • Pricing/P&L • Risk sensitivity calculation • VaR process • Counterparty Credit Risk calculation • Valuation model development and approval cycle • Model lifecycle and corresponding risks • Pre/Post-implementation testing and on-going review • Managing model risk through on-going monitoring and user feedback • How to “backtest” valuation model? • Topics on Model risk assessment and Model Inventory

4. Overview of valuation models used for different products and purposes Products: • Equity Derivatives • Monte Carlo simulation; PDE method; Volatility modeling; • IR Derivatives • HW Tree; BGM Model; • Commodity Derivatives • Semi-analytic; Volatility fitting; • Credit Derivatives • Correlation modeling; CDS curve bootstrapping; • FX Derivatives • Exotic payoff; Volatility skew;

5. Overview of valuation models used for different products and purposes (Cont’d) Purposes: • Pricing/P&L • Daily run, mostly only run once per day, day 0 valuation; • Accuracy; Stability; • Risk sensitivity calculation • Daily run, need to run multiple times per day under various scenarios, single time step; • Performance; Accuracy; Stability; • VaR process • Daily run, run once but under thousands of scenarios, stressed and non-stressed, single time step; • Performance; Stability; • Counterparty Credit Risk calculation • May not need daily run, run once under thousands of scenarios, multiple time step; • Performance; Stability;

6. Valuation model development and approval cycle • Model lifecycle and corresponding risks • Identification of business needs: misapplication of model results; • Development and assessment: errors in application of underlying theory; inaccurate analyses; data process errors; • Approval and deployment: coding errors; challenge model assumptions; • Production: incorrect input data; misapplying model for other than its intended use; • Ongoing maintenance: uncontrolled change; no longer fit for use given changing businesses or economic conditions; • Pre-implementation testing • Pre-implementation assessment done by model owner: coding error; assumption verification; fit for use assessment;

7. Valuation model development and approval cycle (Cont’d) • Post-implementation testing • Needs to be ongoing and repeated periodically; • Verify data availability; • Re-exam model assumptions and limitations under new market conditions; • Review literature for alternative methods; • “Backtesting” • Ongoing model review • Different from post-implementation testing; • Could be carried our more frequently; • Review model actual usage versus approved usage; • Verify compliance against validation recommended actions such as improving the model, ongoing model monitoring;

8. Managing model risk through on-going monitoring and user feedback “Backtesting is a periodic comparison of model values to independently obtained observable results with predefined thresholds of acceptability, in order to assess whether the model outputs are sufficiently accurate in an objective, evidence-based sense.” • How to “backtest” valuation model? • Independent Price Verification • Observable prices • Collateral management process

9. Topics on Model risk assessment and Model Inventory • Model Risk Assessment • Model’s risk rating determines the frequency of post-implementation ongoing model reviews; • Mostly two dimensional: Model complexity and likelihood of problem & Materiality/Impact of problem; • Mostly three to four final ratings: low, medium, high and critical; • Model Inventory • Model owner to maintain its own inventory separate from model validation/governance team; • Periodic re-verification/reconciliation of model inventory; • Help identify unknown model users by periodic verification process;

10. Q & A