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http://ssrn.com/abstract=275075
 
 

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A Methodology to Analyze Model Risk with an Application to Discount Bond Options in a Heath-Jarrow-Morton Framework


Francois Lhabitant


Kedge Capital Fund Management; EDHEC Business School

Mireille Bossy


Institut National de Recherche en Informatique et Automatique (INRIA)

Rajna Gibson


University of Geneva - Graduate School of Business (HEC-Geneva); Swiss Finance Institute

Denis Talay


French National Institute for Research in Computer Science and Control (INRIA)

Nathalie Pistre


National Institute of Statistics and Economic Studies (INSEE) - National School for Statistical and Economic Administration (ENSAE)

June 2001

Risklab Research Report

Abstract:     
In this paper, we propose a general methodology to analyse model risk for discount bond options within a unified Heath, Jarrow, Morton (1992) framework. We illustrate its applicability by focusing on the hedging of discount bond options and options portfolios. We show how to decompose the agent's "model risk" profit and loss, and emphasize the importance of the position's gamma in order to control it. We further provide mathematical results on the distribution of the forward profit and loss function for specific Markov univariate term structure models. Finally, we run numerical simulations for naked and combined option's hedging strategies in order to quantify the sensitivity of the forward profit and loss function with respect to the volatility of the forward rate curve, the shape of the term structure, and the characteristics of the position being hedged.

Number of Pages in PDF File: 42

Keywords: model risk, interest rate risk, Heath-Jarrow-Morton

JEL Classification: G13

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Date posted: July 10, 2001  

Suggested Citation

Lhabitant, Francois and Bossy, Mireille and Gibson , Rajna and Talay, Denis and Pistre, Nathalie, A Methodology to Analyze Model Risk with an Application to Discount Bond Options in a Heath-Jarrow-Morton Framework (June 2001). Risklab Research Report. Available at SSRN: http://ssrn.com/abstract=275075 or http://dx.doi.org/10.2139/ssrn.275075

Contact Information

Francois-Serge Lhabitant (Contact Author)
Kedge Capital Fund Management ( email )
13 Broad Street
St Helier, Jersey JE4 5YQ
HOME PAGE: http://www.lhabitant.net
EDHEC Business School ( email )
58, rue du Port
59046 Lille Cedex
France
Mireille Bossy
Institut National de Recherche en Informatique et Automatique (INRIA)
Rocquencourt
France
Rajna Gibson
University of Geneva - Graduate School of Business (HEC-Geneva) ( email )
40 Boulevard du Pont d'Arve
Geneva 4, 1211
Switzerland
+41.22.379.89.83 (Phone)
Swiss Finance Institute ( email )
c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900
Switzerland

Denis Talay
French National Institute for Research in Computer Science and Control (INRIA) ( email )
2004 route des Lucioles
BP 94
06902 Sophia Antipolis Cedex
France
Nathalie Pistre
National Institute of Statistics and Economic Studies (INSEE) - National School for Statistical and Economic Administration (ENSAE) ( email )
92245 Malakoff Cedex
France
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