Model Risk

III
Michel Crouhy

Michel Crouhy

IXIS Corporate & Investment Bank, A subsidiary of NATIXIS, Paris, France

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Dan Galai

Dan Galai

The Hebrew University, School of Business Administration, Jerusalem, Israel

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Robert Mark

Robert Mark

Black Diamond Risk Enterprises, Pleasant Hill, CA, USA

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First published: 15 September 2008

Abstract

Models are an inevitable feature of modern finance, and model risk is inherent in the use of models. In this article we stress the technical elements of model risk. Models are susceptible to errors: from incorrect assumptions about price dynamics and market interactions, from implementing a model wrongly, from inaccurate estimation of volatilities and correlations and other inputs that are not directly observable and must be forecasted. We also discuss how to mitigate model risk.

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