Model Risk

Because institutions rely heavily on models for pricing financial transactions or monitoring risks, they are exposed to model risk.

This is the risk that models are applied to tasks for which they are inappropriate or are otherwise implemented incorrectly.

Examples of model risk include:

• A bank uses a value at risk (VAR) to monitor market risk. When the VaR measure was implemented, the bank’s traders took little spread risk. It was coded with a fixed spread assumption. Since that time, the traders have started taking significant spread risk but do not realize that the model is failing to capture it.
• Option pricing models incorporate a risk-neutral assumption. Such models may produce erroneous results if used to measure risk or other quantities that depend upon investor risk preferences.
• A brokerage firm is expanding its derivatives operation into South America. They fail to modify their pricing models to reflect the lack of liquidity in certain markets. Consequently, they underestimate the cost of hedging their positions.

Model risk is generally categorized as a form of operational risk.

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