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An investigation of model risk in a market with jumps and stochastic volatility

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  • Coqueret, Guillaume
  • Tavin, Bertrand

Abstract

The aim of this paper is to investigate model risk aspects of variance swaps and forward-start options in a realistic market setup where the underlying asset price process exhibits stochastic volatility and jumps. We devise a general framework in order to provide evidence of the model uncertainty attached to variance swaps and forward-start options. In our study, both variance swaps and forward-start options can be valued by means of analytic methods. We measure model risk using a set of 21 models embedding various dynamics with both continuous and discontinuous sample paths. To conduct our empirical analysis, we work with two major equity indices (S&P 500 and Eurostoxx 50) under different market situations. Our results evaluate model risk between 50 and 200 basis points, with an average value slightly above 100 basis points of the contract notional.

Suggested Citation

  • Coqueret, Guillaume & Tavin, Bertrand, 2016. "An investigation of model risk in a market with jumps and stochastic volatility," European Journal of Operational Research, Elsevier, vol. 253(3), pages 648-658.
  • Handle: RePEc:eee:ejores:v:253:y:2016:i:3:p:648-658
    DOI: 10.1016/j.ejor.2016.03.018
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    9. Ben-zhang Yang & Jia Yue & Nan-jing Huang, 2017. "Variance swaps under L\'{e}vy process with stochastic volatility and stochastic interest rate in incomplete markets," Papers 1712.10105, arXiv.org, revised Mar 2018.
    10. Ben-Zhang Yang & Jia Yue & Nan-Jing Huang, 2019. "Equilibrium Price Of Variance Swaps Under Stochastic Volatility With Lévy Jumps And Stochastic Interest Rate," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 22(04), pages 1-33, June.
    11. Cui, Zhenyu & Lars Kirkby, J. & Nguyen, Duy, 2017. "A general framework for discretely sampled realized variance derivatives in stochastic volatility models with jumps," European Journal of Operational Research, Elsevier, vol. 262(1), pages 381-400.

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