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Model Risk in Option Pricing — Estimation Risk of Volatility Parameter

In: Modern Finance and Risk Management Festschrift in Honour of Hermann Locarek-Junge

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  • Krzysztof Jajuga

Abstract

The advancement of financial theory designed for option pricing based on quantitative methods has been observed in the last 40 years. The main problem of the application of these methods is that these methods may not be well suited to the real world in some cases. This chapter discusses the main background to analyse model risk in option pricing. The chapter concentrates on model risk resulted from uncertainty as to the parameters of the model, which in option pricing is the volatility of the underlying price. The proposal is to measure model risk by sensitivity measures, particularly for the Black–Scholes–Merton model.One of the sources of model risk resulted from the uncertainty of the volatility estimate may result from using the volatility index as this estimate. The empirical example compares expected volatility provided by VIX with realised volatility.

Suggested Citation

  • Krzysztof Jajuga, 2022. "Model Risk in Option Pricing — Estimation Risk of Volatility Parameter," World Scientific Book Chapters, in: Tony Klein & Sven Loßagk & Mario Straßberger & Thomas Walther (ed.), Modern Finance and Risk Management Festschrift in Honour of Hermann Locarek-Junge, chapter 12, pages 269-287, World Scientific Publishing Co. Pte. Ltd..
    • Handle: RePEc:wsi:wschap:9781800611917_0012
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