DEFINITION of 'Model Risk'

A type of risk that occurs when a financial model used to measure a firm's market risks or value transactions does not perform the tasks or capture the risks it was designed to.

Model risk is considered a subset of operational risk, as model risk mostly affects the firm that creates and uses the model. Traders or other investors who use the model may not completely understand its assumptions and limitations, which limits the usefulness and application of the model itself.

BREAKING DOWN 'Model Risk'

Any model is a simplified version of reality, and with any simplification there is the risk that something will fail to be accounted for.

The use of financial models has become very prevalent in the past decades, in step with advances in computing power, software applications and new types of financial securities. The Long Term Capital Management debacle was attributed to model risk - in this case, a small error in the fund's computer models was made larger by several orders of magnitude because of the highly leveraged trading strategy LTCM employed.

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