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Applying hedging strategies to estimate model risk and provision calculation

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  • Alberto Elices
  • Eduard Gim�nez

Abstract

This paper introduces a relative model risk measure of a product priced with a given model, with respect to another reference model by which the market is assumed to be driven. This measure allows a comparison of products valued with different models (pricing hypothesis) under a homogeneous framework. This allows comparing models with respect to the reference which should be chosen to be a market benchmark. The relative model risk measure is defined as the expected shortfall of the hedging strategy at a given time horizon for a chosen significance level. The reference model has been chosen to be Heston’s calibrated to market for a given time horizon. The method is applied to estimate and compare this relative model risk measure under volga--vanna and Black--Scholes models for double-no-touch options and a portfolio of forward fader options.

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  • Alberto Elices & Eduard Gim�nez, 2012. "Applying hedging strategies to estimate model risk and provision calculation," Quantitative Finance, Taylor & Francis Journals, vol. 13(7), pages 1015-1028, October.
    • Handle: RePEc:taf:quantf:v:13:y:2012:i:7:p:1015-1028
    DOI: 10.1080/14697688.2012.741260
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    Cited by:

    1. Alberto Elices, 2012. "The role of the Model Validation function to manage and mitigate model risk," Papers 1211.0225, arXiv.org.

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