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Model Risk

Model risk refers to the risk that arises from the potential inaccuracies or errors in financial models used to make decisions, such as pricing derivatives, managing risk, or conducting valuations. Models are based on assumptions and historical data, and if these inputs are incorrect or incomplete, the model may produce misleading results.

Example

A bank uses a model to price a complex derivative, but due to incorrect assumptions about volatility, the model produces an inaccurate valuation, resulting in a loss.

Key points

• The risk of inaccuracies or errors in financial models that can lead to incorrect decisions or valuations.

• Common in pricing derivatives, risk management, and valuation models.

• Errors in assumptions or data can result in significant financial losses.

Quick Answers to Curious Questions

Model risk arises from potential inaccuracies in financial models used for pricing, risk management, or valuations.

Inaccurate models can lead to incorrect decisions, resulting in financial losses, especially in complex financial instruments.

Companies can manage model risk by validating models, using stress testing, and regularly updating assumptions and data inputs.

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