Scenario Analysis in Charge of Model Selection

Abstract:     
This paper presents how scenario analysis techniques can be used for building financial models that are able to capture the dynamics of the underlying asset prices both in benign periods and in times of stress. The paper presents case studies for building pricing models for equity and FX derivatives. In the course of model calibration, the scenario analysis techniques are applied to identify the shortcomings of the assessed models and to propose improvements. The presented techniques may help in managing model risk and valuation uncertainties, which attracted increased attention in the aftermath of the recent financial crisis.

Number of Pages in PDF File: 18

Keywords: calibration, stochastic volatility, jumps, Lévy processes, model risk

JEL Classification: C51, C52, C61, C63, D46, G12

working papers series