Model risk

In finance, model risk is the risk of loss resulting from using insufficiently accurate models to make decisions, originally and frequently in the context of valuing financial securities. However, model risk is more and more prevalent in activities other than financial securities valuation, such as assigning consumer credit scores, real-time probability prediction of fraudulent credit card transactions, and computing the probability of air flight passenger being a terrorist. Rebonato in 2002 defines model risk as "the risk of occurrence of a significant difference between the mark-to-model value of a complex and/or illiquid instrument, and the price at which the same instrument is revealed to have traded in the market".

Case studies: Merrill Lynch (1970s; $70m loss) - for stripped bonds, used a single par yield instead of separate annuity yield-curves and zero-coupon curves for the resultant IO and PO securities. NatWest (1997; £90m loss) - incorrect model specification, "a naive volatility input in their systems", for interest rate options and swaptions. Bank of Tokyo-Mitsubishi (1997; $83m loss) - a "systematic pricing bias" for out-of-the-money and Bermuda swaptions which had been calibrated to at-the-money vanilla swaptions. Barclays de Zoete Wedd (1997; £15m loss) - mispriced currency options. LTCM (1998; required $3.65 billion in recapitalization) - risk models had drastically under-estimated the risks of a profound economic crisis, due to an insufficient data-window and a lack of stress testing. National Australia Bank (2001; $2.2 Billion AUD loss) - its Homeside interest rate model made inconsistent use of rates. 2007–2012 global financial crisis – Over-reliance on David X. Li's Gaussian copula model misprices the risk of collateralized debt obligations.

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