Model Risk and Its Control

In this paper, we analyze model risks separately in pricing models and risk measurement models as follows. (1) In pricing models, model risk is defined as the risk arising from the use of a model which cannot accurately evaluate market prices, or which is not a mainstream model in the market. (2) In risk measurement models, model risk is defined as the risk of not accurately estimating the probability of future losses. Based on these definitions, we examine various specific cases and numerical examples to determine the sources of model risks and to discuss possible steps to control these risks.