Model Risk

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.

RELATED TERMS
  1. Financial Modeling

    The process by which a firm constructs a financial representation ...
  2. Coefficient of Determination

    A measure used in statistical model analysis to assess how well ...
  3. Business Model

    The plan implemented by a company to generate revenue and make ...
  4. Hull–White Model

    A single-factor interest model used to price derivatives. The ...
  5. Versioning

    A business practice in which a company produces different models ...
  6. Anomaly

    A term describing the incidence when the actual result under ...
Related Articles
  1. Economics

    What is a Business Model?

    Business model is the term for a company’s plan as to how it will earn revenue.
  2. Investing

    Understanding Financial Models

    A financial model is a representation of some aspects of a firm or given security. It uses historical numbers to create calculations that inform financial recommendations or predict future financial ...
  3. Trading Systems & Software

    Build a Profitable Trading Model In 7 Easy Steps

    Trading models can provide a powerful tool for building profit. Traders can use and customize existing trading models or build an original model. This article provides seven steps to building ...
  4. Professionals

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  5. Forex Strategies

    How to Build A Forex Trading Model

    Forex trading markets work 24/7, providing ample opportunities to make profitable trades. How can you build a profitable forex trading model for yourself?
  6. Investing News

    How Do Professionals Forecast Crude Oil Prices?

    Discover how the future price of oil is predicted with a weighted combination of mathematical tools. Economists largely use five main models as their base.
  7. Trading Strategies

    Pairs Trading: Risks

    Although pure arbitrage is essentially a risk-free strategy, pairs trading (either as relative value arbitrage or StatArb) involves certain risks, including model risk and execution risk. Model ...
  8. Professionals

    The Best Financial Modeling Courses for Investment Bankers

    Obtain information, both general and comparative, about the best available financial modeling courses for individuals pursuing a career in investment banking.
  9. Forex Strategies

    How To Build A Forex Trading Model

    The forex market is volatile, but a forex trading model with clear, step-by-step rules based on a sound strategy can help decrease losing trades.
  10. Professionals

    Common Stock Valuation

    No one valuation method is perfect for every situation, but by knowing the characteristics of the company, you can select the valuation method that best suits the situation
RELATED FAQS
  1. What is the difference between financial forecasting and financial modelling?

    Understand the difference between financial forecasting and financial modeling, and learn why a company should conduct both ... Read Answer >>
  2. What is the average return on equity for a company in the electronics sector?

    Learn about the Black-Scholes option pricing model and the binomial options model, and understand the advantages of the binomial ... Read Answer >>
  3. What are some examples of different types of business models in major industries?

    Learn what types of business models are currently being used in the marketplace as well as examples of models that work for ... Read Answer >>
  4. What is the point of developing a business model?

    Learn some of the benefits of developing a business model and how business models are used. Consider an example of business ... Read Answer >>
  5. What do you need to know to create a business model?

    Learn what a business model is, its importance and the primary elements that are needed in order to create a successful business ... Read Answer >>
  6. What are the advantages and disadvantages of the Gordon Growth Model?

    Understand the advantages and disadvantages of using the Gordon Growth Model to value a company's publicly traded stock. ... Read Answer >>
Hot Definitions
  1. Goodwill

    An account that can be found in the assets portion of a company's balance sheet. Goodwill can often arise when one company ...
  2. Return On Invested Capital - ROIC

    A calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. ...
  3. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  4. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  5. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  6. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
Trading Center