Modern finance would not have been possible without models. Increasingly complex quantitative models drive financial innovation and the growth of derivatives markets. Models are necessary to value financial instruments and to measure the risks of individual positions and portfolios. Yet when used inappropriately, the models themselves can become an important source of risk. Recently, several well-publicized instances occurred of institutions suffering significant losses attributed to model error. This has sharpened the interest in model risk among financial institutions and their regulators.
This article describes various models and discusses model errors characteristic of two types -- valuation models for individual securities, and models of market risk. It also reviews a number of practical issues related to model development and describes the approach taken by bank regulators to model risk. The author points out that a trade-off almost always exists between the realism and the analytical tractability of a model. Striking the right balance in the face of this trade-off, she writes, and maintaining it through changing market conditions for different financial instruments, is more art than science and requires considerable experience and judgment.