DEFINITION of Model Risk
Model risk is a type of risk that occurs when a financial model used to measure a firm's market risks or value transactions fails or performs inadequately.
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. Assumptions made to develop a model and inputs into the model can vary widely. 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.
Memorable Examples of Model Risk
The Long Term Capital Management (LTCM) debacle in 1998 was attributed to model risk. In this case, a small error in the firm's computer models was made larger by several orders of magnitude because of the highly leveraged trading strategy LTCM employed. LTCM famously had two Nobel Prize winners in Economics, but the firm imploded due to its financial model that failed in that particular market environment.
Almost 15 years later JPMorgan Chase (JPM) suffered massive trading losses from a VaR model that contained formula and operational errors. In 2012, CEO Jaime Dimon's proclaimed "tempest in a teapot" turned out to be $6.2 billion loss resulting from trades gone wrong in its synthetic credit portfolio (SCP). A trader had established large derivative positions that were flagged by the VaR model that existed at the time. In response, the bank's chief investment officer made adjustments to the VaR model, but due to a spreadsheet error in the model trading losses were allowed to pile up without warning signals from the model.