What is model risk?
It's a form of risk that happens when a financial model used to measure a company's market risks or value transactions doesn't do the tasks or capture the risks it was intended to. In other words, it's the risk of loss resulting from using inaccurate models to reach decisions.
Where have you heard about model risk?
The use of financial models has become very popular in recent decades as computing power and software applications have advanced. The Long Term Capital Management scandal in 1998 was attributed to model risk, as a small error in computer models was magnified by LTCM's highly leveraged trading strategy.
What you need to know about model risk.
Model risk mainly affects the firm that creates and uses the flawed model, and it's therefore considered to be a subset of operational risk . Investors who use the model might not fully understand its assumptions and limitations, which in turn limits the model's usefulness.
Model risk can occur for various reasons, including uncertainty on volatility or correlation parameters, the complexity of a model or financial contract, and market illiquidity. Model risk can be mitigated by thorough stress testing, independent validation and ongoing monitoring against the market.