What is Validation of Models?
Validation is the “proof ” that a model works as intended. As an example, while it is a useful tool to test a model’s risk sensitivity, it is less useful for testing the accuracy of high quantiles in a loss distribution. The validation of economic capital models differs from the valuation of an IRB (internal-ratings based) model because the output of economic capital models is distribution rather than a single predicted forecast against which actual outcomes may be compared. Also, economic capital models are quite similar to VaR models despite the longer time horizons, higher confidence levels, and greater lack of data.
Why is validation of models important?
Validation ensures that the model’s depiction of the real system is accurate. “Support that a computerised model within its sphere of applicability has a suitable range of accuracy commensurate with the model’s intended application,” according to the definition of model validation.