Model Risk

Abstract

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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