However, model risk is increasingly relevant in contexts other than financial securities valuation, including assigning consumer credit scores, real-time prediction of fraudulent credit card transactions, and computing the probability of an air flight passenger being a terrorist.
Derman believes that products whose value depends on a volatility smile are most likely to suffer from model risk.
"[11] Avellaneda & Paras (1995) proposed a systematic way of studying and mitigating model risk resulting from volatility uncertainty.
[12] Buraschi and Corielli formalise the concept of 'time inconsistency' with regards to no-arbitrage models that allow for a perfect fit of the term structure of the interest rates.
He prices these derivatives with various copulas and concludes that "... unless one is very sure about the dependence structure governing the credit basket, any investors willing to trade basket default products should imperatively compute prices under alternative copula specifications and verify the estimation errors of their simulation to know at least the model risks they run".
This factor was cited as a major source of model risk for mortgage backed securities portfolios during the 2007 crisis.
Hedge funds that trade these securities can be exposed to model risk when calculating monthly NAV for its investors.
[18] Mitigation strategies include adding consistency checks, validating inputs, and using specialized tools.
[22] In this approach one considers a range of models and minimizes the loss encountered in the worst-case scenario.
[27] Fender and Kiff (2004) note that holding complex financial instruments, such as CDOs, "translates into heightened dependence on these assumptions and, thus, higher model risk.