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Applying hedging strategies to estimate model risk and provision calculation

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  • Alberto Elices
  • Eduard Gim'enez

Abstract

This paper introduces a relative model risk measure of a product priced with a given model, with respect to another reference model for which the market is assumed to be driven. This measure allows comparing products valued with different models (pricing hypothesis) under a homogeneous framework which allows concluding which model is the closest to the reference. 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 calibrated to market for a given time horizon (this reference model should be chosen to be a market proxy). 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.

Suggested Citation

  • Alberto Elices & Eduard Gim'enez, 2011. "Applying hedging strategies to estimate model risk and provision calculation," Papers 1102.3534, arXiv.org, revised Oct 2012.
  • Handle: RePEc:arx:papers:1102.3534
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    File URL: http://arxiv.org/pdf/1102.3534
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