What is Model Risk?

Legal Definition
In finance, model risk is the risk of loss resulting from using models to make decisions, initially and frequently in the context of valuing financial securities. However, model risk is more and more prevalent in activities other than financial securities valuation, such as assigning consumer credit scores, real-time probability prediction of fraudulent credit card transactions, and computing the probability of air flight passenger being a terrorist. Rebonato in 2002 considers alternative definitions including:

  1. After observing a set of prices for the underlying and hedging instruments, different but identically calibrated models might produce different prices for the same exotic product.
  2. Losses will be incurred because of an ‘incorrect’ hedging strategy suggested by a model.

Rebonato defines model risk as "the risk of occurrence of a significant difference between the mark-to-model value of a complex and/or illiquid instrument, and the price at which the same instrument is revealed to have traded in the market."
-- Wikipedia
Legal Definition
Probability of loss resulting from the weaknesses in the financial model used in assessing and managing a risk.