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Model Uncertainty And Its Impact On The Pricing Of Derivative Instruments

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  • Rama Cont

Abstract

Uncertainty on the choice of an option pricing model can lead to “model risk” in the valuation of portfolios of options. After discussing some properties which a quantitative measure of model uncertainty should verify in order to be useful and relevant in the context of risk management of derivative instruments, we introduce a quantitative framework for measuring model uncertainty in the context of derivative pricing. Two methods are proposed: the first method is based on a coherent risk measure compatible with market prices of derivatives, while the second method is based on a convex risk measure. Our measures of model risk lead to a premium for model uncertainty which is comparable to other risk measures and compatible with observations of market prices of a set of benchmark derivatives. Finally, we discuss some implications for the management of “model risk.”

Suggested Citation

  • Rama Cont, 2006. "Model Uncertainty And Its Impact On The Pricing Of Derivative Instruments," Mathematical Finance, Wiley Blackwell, vol. 16(3), pages 519-547, July.
  • Handle: RePEc:bla:mathfi:v:16:y:2006:i:3:p:519-547
    DOI: 10.1111/j.1467-9965.2006.00281.x
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    File URL: https://doi.org/10.1111/j.1467-9965.2006.00281.x
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