A model is a simplified representation of reality and rests on assumptions. Model risk does not refer only to calculation errors. It also includes using a sound model outside the environment it was designed for12.

Consider a hypothetical example in which a model values a transaction at 1.0 billion yen, and the transaction is concluded in the market at 0.95 billion yen. If the valuation follows the model's value, the 50 million yen difference is a valuation loss. If it is concluded at 1.04 billion yen, there is a valuation gain of 40 million yen, but it remains true that the model does not reproduce the price at which the transaction is concluded.

Notes

  1. Financial Services Agency, "モデル・リスク管理に関する原則" (Principles for Model Risk Management) (November 12, 2021), "Ⅲ. 定義" (Definitions) (b), page 5 (in Japanese). ↩

  2. Board of Governors of the Federal Reserve System and Office of the Comptroller of the Currency (OCC), "Supervisory Guidance on Model Risk Management" (April 4, 2011), "III. Overview of Model Risk Management", pages 3–4. ↩