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Concept
Model risk
Summary
In finance, model risk is the risk of loss resulting from using insufficiently accurate models to make decisions, originally and frequently in the context of valuing financial securities. However, model risk is more and more prevalent in activities other than financial securities valuation, such as assigning consumer credit scores, real-time probability prediction of fraudulent credit card transactions, and computing the probability of air flight passenger being a terrorist. Rebonato in 2002 defines model risk as "the risk of occurrence of a significant difference between the mark-to-model value of a complex and/or illiquid instrument, and the price at which the same instrument is revealed to have traded in the market".
Burke regards failure to use a model (instead over-relying on expert judgment) as a type of model risk. Derman describes various types of model risk that arise from using a model:
Inapplicability of model.
Incorrect model specification.
Programming errors.
Technical errors.
Use of inaccurate numerical approximations.
Implementation risk.
Data issues.
Calibration errors.
Volatility is the most important input in risk management models and pricing models. Uncertainty on volatility leads to model risk. Derman believes that products whose value depends on a volatility smile are most likely to suffer from model risk. He writes "I would think it's safe to say that there is no area where model risk is more of an issue than in the modeling of the volatility smile."
Avellaneda & Paras (1995) proposed a systematic way of studying and mitigating model risk resulting from volatility uncertainty.
Buraschi and Corielli formalise the concept of 'time inconsistency' with regards to no-arbitrage models that allow for a perfect fit of the term structure of the interest rates. In these models the current yield curve is an input so that new observations on the yield curve can be used to update the model at regular frequencies. They explore the issue of time-consistent and self-financing strategies in this class of models.
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