How much is a model upgrade worth?

Sven Sandow, Jinggang Huang and Craig Friedman

Abstract

ABSTRACT

In order to shed light on cost–benefit trade-offs faced by financial model builders and purchasers, we construct a practical, easily implemented monetary measure of the differential performance between probabilistic models. To this end, we adopt the point of view of an investor who maximizes his expected utility under the model he believes. We explore general properties of the monetary value of a model upgrade and investigate a variety of important special cases. We develop explicit formulas that can be applied in realistic settings by practitioners, for example, to default probability models, which are of fundamental importance to banks and other participants in the multi-trillion dollar credit markets. We provide a case study in this context.