Model risk, has a number of sources:
Ω The data input can be wrong
Ω One may wrongly estimate a key parameter of the model
Ω The model may be flawed or incorrect
Ω Models may give rise to significant hedging risk.
In fact, when most people talk about model risk they are referring to the risk of
flawed or incorrect models. Modern traders often rely heavily on the use of mathematical
models that involve complex equations and advanced mathematics. Flaws may
be caused by mistakes in the setting of equations, or wrong assumptions may have
been made about the underlying asset price process. For example, a model may be
based on a flat and fixed term structure, while the actual term structure of interest
rates is steep and unstable.
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