Chapter 2: Risk assessment and risk management in economics
Assessing and managing risks is typically based on the assumption that all possible states of the nature and the probability of their occurrence are known. This assumption allows corporate decision makers, policy makers and regulators alike to apply economic and risk models that use statistical loss distributions and to set up strategies to adjust risks. Real-life economic situations, however, are characterized by ambiguity, which means a considerable lack of information regarding potential outcomes and the probability of their occurrence. By applying simplifying assumptions decision makers try to make ambiguity measurable. In this sense, risk represents the threat that a specific economic outcome falls short of respective target values. The application of economic and risk models, however, creates an additional risk category. This so-called model risk follows either from (1) the use of a model that does not fit the situation (over-optimism), (2) the use of a model in a different way from or with a purpose other than that allowed (ignorance), or (3) the non-use of a model that would fit the situation (agnosticism). In this chapter we analyse the causes of model risk and possible adverse consequences for stakeholders. Specifically, we focus on potentially inadequate decision making and on the illusion of control. In addition, we discuss possibilities to mitigate model risk on the basis of model risk management. Key Words: Risk assessment, Risk management, Risk models, Model risk
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