Model Risk of Contingent Claims

31 Pages Posted: 13 Feb 2013 Last revised: 30 Nov 2014

Nils Detering

University of California Santa Barbara

Natalie Packham

Berlin School of Economics and Law

Date Written: November 29, 2014

Abstract

Paralleling regulatory developments, we devise value-at-risk and expected shortfall type risk measures for the potential losses arising from using misspecified models when pricing and hedging contingent claims. Essentially, losses from model risk correspond to losses realized on a perfectly hedged position. Model uncertainty is expressed by a set of pricing models, relative to which potential losses are determined. Using market data, a unified loss distribution is attained by weighing models according to a relative likelihood criterion. Examples demonstrate the magnitude of model risk and corresponding capital buffers necessary to sufficiently protect trading book positions against unexpected losses from model risk.

Keywords: model risk, parameter uncertainty, hedge error, value-at-risk, expected shortfall

JEL Classification: G32, G13

Suggested Citation

Detering, Nils and Packham, Natalie, Model Risk of Contingent Claims (November 29, 2014). Available at SSRN: https://ssrn.com/abstract=2214913 or http://dx.doi.org/10.2139/ssrn.2214913

Nils Detering (Contact Author)

University of California Santa Barbara ( email )

Natalie Packham

Berlin School of Economics and Law ( email )

Badensche Strasse 50-51
Berlin, D-10825
Germany

HOME PAGE: http://www.packham.net

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