Hedging Valuation Adjustment for Callable Claims

Cyril Bénézet (cyril.benezet@polytechnique.edu), Stéphane Crépey (stephane.crepey@univ-evry.fr) and Dounia Essaket
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Cyril Bénézet: LaMME - Laboratoire de Mathématiques et Modélisation d'Evry - ENSIIE - Ecole Nationale Supérieure d'Informatique pour l'Industrie et l'Entreprise - UEVE - Université d'Évry-Val-d'Essonne - Université Paris-Saclay - CNRS - Centre National de la Recherche Scientifique - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement, ENSIIE - Ecole Nationale Supérieure d'Informatique pour l'Industrie et l'Entreprise
Stéphane Crépey: LPSM (UMR_8001) - Laboratoire de Probabilités, Statistique et Modélisation - SU - Sorbonne Université - CNRS - Centre National de la Recherche Scientifique - UPCité - Université Paris Cité, UPCité - Université Paris Cité
Dounia Essaket: LPSM (UMR_8001) - Laboratoire de Probabilités, Statistique et Modélisation - SU - Sorbonne Université - CNRS - Centre National de la Recherche Scientifique - UPCité - Université Paris Cité, UPCité - Université Paris Cité

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Abstract: In this work, we extend to callable assets the model risk approach of Bénézet and Crépey (2024), itself leveraging on the notion of hedging valuation adjustment initially introduced for dealing with transaction costs in Burnett (2021) & Burnett and Williams (2021). The classical way to deal with model risk is to reserve the differences between the valuations in reference models and in the local models used by traders. However, while traders' prices are thus corrected, their hedging strategies and their exercise decisions are still wrong, which necessitates a risk-adjusted reserve. We illustrate our approach on a stylized callable range accrual representative of huge amounts of structured products on the market. We show that a model risk reserve adjusted for the risk of wrong exercise decisions may largely exceed a basic reserve only accounting for valuation differences.

Keywords: Pricing models; Callable assets; Early Exercise; Model risk; Model calibration; Cross Valuation Adjustments (XVAs); Risk Management (q-fin.RM); Probability (math.PR); Computational Finance (q-fin.CP); FOS: Economics and business; FOS: Mathematics (search for similar items in EconPapers)
Date: 2025-02-24
New Economics Papers: this item is included in nep-ban and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:hal:wpaper:hal-04057045

DOI: 10.48550/arXiv.2304.02479

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