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.

RELATED TERMS
  1. Fed Model

    The Fed model is a tool used to determine whether the U.S. stock ...
  2. Lattice-Based Model

    A lattice-based model is a model used to value derivatives; it ...
  3. Predictive Modeling

    Predictive modeling is the process of using known results to ...
  4. Gordon Growth Model

    The Gordon Growth Model is used to determine the intrinsic value ...
  5. Market Risk

    Market risk is the possibility of an investor experiencing losses ...
  6. Barra Risk Factor Analysis

    The Barra Risk Factor Analysis is a multi-factor model, created ...
Related Articles
  1. Trading

    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 ...
  2. Personal Finance

    Discounted cash flows or comparables: Which to use

    DCF and comparables models are widely used in equity valuation, and here we'll explain the pros and cons of each method.
  3. Personal Finance

    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.
  4. Investing

    Musk Hands Over First Keys to Tesla Model 3 Owners

    The first set of Model 3 owners, who are Tesla employees, will receive the keys to their cars from CEO Elon Musk.
  5. Investing

    Value at Risk (VaR)

    Value at risk, often referred to as VaR, measures the amount of potential loss that could happen in an investment or a portfolio of investments over a given time period.
  6. Personal Finance

    Tesla Reveals First Mass Market Electric Vehicle (TSLA)

    Tesla yesterday unveiled the world's first mass-market electric vehicle. Will it succeed?
  7. Investing

    Fidelity Offers Advisors Help With Model Portfolios

    Fidelity Investments is helping advisors construct portfolios with its new Fidelity Model Portfolios service.
  8. Investing

    How Tesla's 'iPhone Moment' Paved the Way for the Model 3

    The $70,000 Model S has solidified Tesla's brand as the electric car leader
RELATED FAQS
  1. 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 >>
  2. How do subscription business models work?

    Understand how a subscription business model works and why companies prefer a subscription business model over a traditional ... Read Answer >>
  3. How to calculate Value at Risk (VaR) in Excel

    Learn what value at risk is, what it indicates about a portfolio and how to calculate the value at risk of a portfolio using ... Read Answer >>
  4. What's the difference between EaR, Value at Risk (VaR), and EVE?

    Learn about earnings at risk, value at risk and economic value added, how these risk measures are used, and the difference ... Read Answer >>
  5. What is stress testing in Value at Risk (VaR)?

    Discover the difference between Value at Risk, or VaR, and stress testing, and learn how the two concepts might be used together ... Read Answer >>
  6. What are the major categories of financial risk for a company?

    Examine four major categories of financial risk for a business that represent potential problems that a company may have ... Read Answer >>
Trading Center