Model risk

Model risk relates to the risks involved in the erroneous use of models to value and
hedge securities and is typically defined as a component of operational risk. It may
seem to be insignificant for simple instruments (such as stocks and straight bonds)
but can become a major operational risk for institutions that trade sophisticated
OTC derivative products and execute complex arbitrage strategies.
The market price is (on average) the best indicator of an asset’s value in liquid (and
more or less efficient) securities markets. However, in the absence of such a price
discovery mechanism, theoretical valuation models are required to ‘mark-to-model’
the position. In these circumstances the trader and the risk manager are like the
pilot and co-pilot of a plane which flies under Instrument Flight Rules (IFR), relying
only on sophisticated instruments to land the aircraft. An error in the electronics on
board can be fatal to the plane.