Model risk

Model risk does not only exist for complex financial contracts.

Uncertainty on correlation parameters is another important source of model risk.

Cont (2006) advocates the use of model risk exposure for computing such reserves.

Many focus on scorecard management practices and on controlling model risk.

In addition, an important aspect of managing valuation risk is associated with model risk.

In finance, model risk is the risk involved in using models to value financial securities.

This factor was cited as a major source of model risk for mortgage backed securities portfolios during the 2007 crisis.

Derman believes that products whose value depends on a volatility smile are most likely to suffer from model risk.

Such a measure may be used as a way of determining a reserve for model risk for derivatives portfolios.

Uncertainty on volatility leads to model risk.

Model risk affects all the three main steps of risk management: specification, estimation and implementation.

Gennheimer investigates the model risk present in pricing basket default derivatives.

Another risk of leverage is model risk.

This gravely impacts corporate ability to manage model risk, or to ensure that the positions being held are correctly valued.

Derman describes various types of model risk that arise from using a model:

Event tree analysis is a logical evaluative process which works by tracing forward in time or forwards through a causal chain to model risk.

Burke regards failure to use a model (instead over-relying on expert judgment) as a type of model risk.

Levin: Have you found safety and soundness concerns in the VaR model risk management?

Kato and Yoshiba discuss qualitative and quantitative ways of controlling model risk.

Avellaneda & Paras (1995) proposed a systematic way of studying and mitigating model risk resulting from volatility uncertainty.

Hedge funds that trade these securities can be exposed to model risk when calculating monthly NAV for its investors.

Complexity of a model or a financial contract may be a source of model risk, leading to incorrect identification of its risk factors.

Another approach to model risk is the worst-case, or minmax approach, advocated in decision theory by Gilboa and Schmeidler.

A measure of exposure to model risk is then given by the difference between the current portfolio valuation and the worst-case valuation under the benchmark models.

This Model risk is the subject of ongoing research by finance academics, and is a topic of great, and growing, interest in the risk management arena.