In finance, model risk is the risk of loss resulting from using models to make decisions, initially and frequently referring to valuing financial securities. However model risk is more and more prevalent in industries other than financial securities valuation, such as consumer credit score, real-time probability prediction of a fradulent credit card transaction to the probability of air flight passenger being a terrorist. Rebonato in 2002 considers alternative definitions including:
- After observing a set of prices for the underlying and hedging instruments, different but identically calibrated models might produce different prices for the same exotic product.
- Losses will be incurred because of an ‘incorrect’ hedging strategy suggested by a model.
Rebonato 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."
Read more about Model Risk: Types of Model Risk, Case Studies, See Also
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