This entry examines the subject of model risk. Loosely speaking, model risk is the risk of error in the valuations produced by a pricing model or in the estimated risk measures produced by a risk model. The nature of model risk and its diverse causes and manifestations are examined. The entry also briefly addresses the scale of the problem and the dangers it entails, and then goes on to discuss ways in which model risk can be managed.
MODELS AND MODEL RISK
A model can be defined as “a simplified description of reality that is at least potentially useful in decision-making” (Geweke, 2005, p. 7). A model attempts to identify the key features of whatever it is meant to represent and is, by its very nature, a highly simplified structure. We should therefore not expect any model to give a perfect answer: Some degree ...