Model risk and model choice in the case of barrier options and bonus certificates

Rainer Baule and David Shkel

Journal of Banking & Finance, 2021, vol. 133, issue C

Abstract: In the pricing of exotic options, model risk arises when different models yield different prices, even though they are calibrated to the same observable prices of plain vanilla options. We analyze model risk in the case of barrier options and bonus certificates. This study uses an empirical data set of over 40,000 certificates to analyze the real market extent of model risk for traded barrier options. In particular, applying the local volatility model, the Heston model, and the Bates model, theoretical model risk amounts to about 8.5% (median) of the barrier option value. In contrast, the median empirical model risk, based on the range of market prices, is only 2.2%. We find evidence that the majority of issuers prefer stochastic volatility over local volatility models. Model risk is a factor priced into issuers’ margin policy—that is, they let retail customers pay for their model risk.

Keywords: Model risk; Heston model; Bates model; Local volatility; Bonus certificates; Barrier options; Empirical finance; Retail derivatives (search for similar items in EconPapers)
JEL-codes: C61 C63 G12 G13 (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0378426621002594
Full text for ScienceDirect subscribers only

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:133:y:2021:i:c:s0378426621002594

DOI: 10.1016/j.jbankfin.2021.106307

Access Statistics for this article

Journal of Banking & Finance is currently edited by Ike Mathur

More articles in Journal of Banking & Finance from Elsevier
Bibliographic data for series maintained by Catherine Liu ().