Applying hedging strategies to estimate model risk and provision calculation

Alberto Elices and Eduard Gim�nez

Quantitative Finance, 2012, vol. 13, issue 7, 1015-1028

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

Date: 2012
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DOI: 10.1080/14697688.2012.741260

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