MODEL ERROR

Modern finance would not have been possible without models. Increasing ly complex quantitative models drive financial innovation and the grow th of derivatives markets. Models are necessary to value financial ins truments and to measure the risks of individual positions and portfoli os. 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 m odel error. This has sharpened the interest in model risk among financ ial institutions and their regulators. This article describes various models and discusses model errors characteristic of two types - valuat ion models for individual securities, and models of market risk. It al so reviews a number of practical issues related to model development a nd describes the approach taken by bank regulators to model risk. The author points out that a trade-off almost always exists between the re alism and the analytical tractability of a model. Striking the right b alance in the face of this trade-off, she writes, and maintaining it t hrough changing market conditions for different financial instruments, is more art than science and requires considerable and judgment.