On Model Risk

I mentioned in my last posting that I am frequently asked to explain in practical terms what is meant and implied by financial modeling and risk analysis. However, the better question would be to ask about the meaning and nature of model risk in financial economics. Here is a pragmatic definition of model risk offered by Dr Riccardo Rebonato (2002):

Model risk is 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.

Dr Rebonato's "definition" is more of an operationalization, which nevertheless offers useful guidance for analyzing model risk in practice. Financial modeling and risk analysis are legacy concepts; the front of mind practical issue of our time centers on model risk and its implications.

Source: Rebonato, R (2002), "Theory and Practice of Model Risk Management,” Unpublished manuscript.