Models are approximations to reality. They are necessary for determining the price at which an instrument should be traded. They are also necessary for valuing and hedging a financial institution's position in an instrument once it has been traded.
Model risk is a type of operational risk. There are two main types of model risk. One is the risk that the model will give the wrong price at the time a product is bought or sold. This can result in a company buying a product for a price that is too high or selling it for a price that is too low. The other risk concerns hedging. If a company uses the wrong model, the Greek letters it calculates—and the hedges it sets up based on those Greek letters—are liable to be wrong.
The art of building a model for valuing a financial product is to capture the key features of the product without allowing the model to become so complicated that it is difficult to use. This chapter contrasts the way models are used in finance with the way they are used by physicists and other scientists. It discusses how models are used for products that are traded actively and how they are used for customized products for which there are no market prices. It describes different types of model risk and how they can be managed.
We start with a discussion of marking to market. As explained in Sections 2.7 and 15.6, a financial institution is required to value its trading book each day. This process is referred to as ...