Model Risk in Option Pricing — Estimation Risk of Volatility Parameter

Krzysztof Jajuga

Chapter 12 in Modern Finance and Risk Management:Festschrift in Honour of Hermann Locarek-Junge, 2022, pp 269-287 from World Scientific Publishing Co. Pte. Ltd.

Abstract: The advancement of financial theory designed for option pricing based on quantitative methods has been observed in the last 40 years. The main problem of the application of these methods is that these methods may not be well suited to the real world in some cases. This chapter discusses the main background to analyse model risk in option pricing. The chapter concentrates on model risk resulted from uncertainty as to the parameters of the model, which in option pricing is the volatility of the underlying price. The proposal is to measure model risk by sensitivity measures, particularly for the Black–Scholes–Merton model.One of the sources of model risk resulted from the uncertainty of the volatility estimate may result from using the volatility index as this estimate. The empirical example compares expected volatility provided by VIX with realised volatility.

Keywords: Finance; Risk Management; Commodities; Energy Finance; Risk; Cryptocurrencies; Asset Management; Banking; Behavioral Finance; Behavioural Finance; Markowitz; Portfolio Selection; Asset Allocation; Crowdfunding; COVID; Pandemic; Corona; Investment Strategies; Low-Risk Investments; Social Banks; Excess Liquidity; Cost of Capital; Utilities; Network Industries; Private Equity; Small and Medium-Sized Enterprises; Black Swan; Statistical Inference; Maximum Likelihood; Bayesian Methods; Tail Risks; Conditional Value-at-Risk; Tail Nonlinearly Transformed Risk; Capital Constraints; Bank Regulation; Subjective Risk Assessment; Expert Knowledge; Model Risk; Risk Factors; Option Pricing; Volatility; Resilience; Supply Chains; Disruption; Systemic Risk; Oil; Renewable Energies; Corporate Risk Management; Power Purchase Agreements; Gold; Precious Metals; Dynamic Correlation; Mixed Data Sampling (search for similar items in EconPapers)
JEL-codes: G11 G3 G32 G4 (search for similar items in EconPapers)
Date: 2022
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