Model Risk, or the Risk of Using Models

Danny Dieleman and Vijay Krishnaswamy

This article was first published as a chapter in Managing Illiquid Assets: Perspectives and Challenges, by Risk Books.

As far as the laws of mathematics refer to reality, they are not certain, and as far as they are certain, they do not refer to reality.

Albert Einstein (1921)

The previous chapters have highlighted the role of models in valuation of illiquid assets. In this chapter we address the resulting model risk, ie, the risk of using models. A number of articles with a highly technical exposition of model risk already exist. In this chapter, however, we take a non-technical but comprehensive view of the topic, as it is critical that users of models understand the risk. This chapter is structured along three themes. First, we highlight the importance of model risk. Then we formally define what it means, discuss the implications of model risk for valuation purposes, and explain the relevance of accounting rules, since these rules determine how the model risks for valuation materialise in the financial accounts. Finally, we explain typical sources of model risk and offer a menu of ideas to manage and mitigate this risk. Some of the ideas presented here are described in more