Hedging Valuation Adjustment and Model Risk

The dynamic hedging theory only makes sense in the setup of one given model, whereas the practice of dynamic hedging is just the opposite, with models fleeing after the data through daily recalibration. In this paper we revisit Burnett (2021) & Burnett and Williams (2021)'s notion of hedging valuation adjustment (HVA), originally intended to deal with dynamic hedging frictions, in the direction of model risk. We formalize and quantify Darwinian model risk as introduced in Albanese, Crépey, and Iabichino (2021), in which traders select models producing short to medium term gains at the cost of large but distant losses. The corresponding HVA can be seen as the bridge between a global fair valuation model and the local models used by the different desks of the bank. Importantly, model risk and dynamic hedging frictions indeed deserve a reserve, but a risk-adjusted one, so not only an HVA, but also a contribution to the KVA of the bank. The orders of magnitude of the effects involved suggest that bad models should not so much be managed via reserves, as excluded altogether. Model risk on CVA and FVA metrics is also considered.