Interest rate model risk: an overview

ABSTRACT Model risk is becoming an increasingly important concept not only in financial valuation but also for risk management issues and capital adequacy purposes. Model risk arises as a consequence of incorrect modeling, model identification or specification errors, and inadequate estimation procedures, as well as from the application of mathematical and statistical properties of financial models in imperfect financial markets. In this paper, the authors provide a definition of model risk, identify its possible origins, and list the potential problems, before finally illustrating some of its consequences in the context of the valuation and risk management of interest rate contingent claims.