Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 8. Model Risk

KEVIN DOWD, PhD

Professor of Financial Risk Management, Centre for Risk and Insurance Studies, Nottingham University Business School

Abstract: Model risk is the risk of error in pricing or risk-forecasting (such as value at risk, or VaR) models. It arises in part because any model involves simplification and calibration, and both of these require subjective judgments that are inevitably open to error. Model risk can also arise where a model is used inappropriately. Model risk is therefore an inescapable consequence of model use, and there is abundant anecdotal and other evidence that it is a major problem, especially for VaR models. However, there are also many ways in which risk managers and financial institutions can manage this problem.

Keywords: model, pricing models, VaR models, model risk, endogenous model risk, parameter risk, implementation risk

This chapter examines the subject of model risk. Loosely speaking, model risk is the risk of error in the valuations produced by a pricing model or the estimated risk measures produced by a risk model. The nature of model risk, and its diverse causes and manifestations, are examined It 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 ...