Measuring the Model Risk of Quadratic Risk Minimizing Hedging Strategies with an Application to Energy Markets

21 Pages Posted: 25 Feb 2014 Last revised: 7 Nov 2014

See all articles by Nils Detering

Nils Detering

University of California, Santa Barbara (UCSB)

Date Written: February 26, 2014

Abstract

Measures of model risk based on the residual error from hedging in a misspecified model were recently proposed in (Detering and Packham, 2013). These measures rely on the assumption that the model used for hedging represents a complete financial market. We show that under certain conditions, in a diffusion setup, markets can be completed to derive measures of model risk for the original market. If the market can not be completed, as it is the case in most market models that allow for jumps, we derive measures that are applicable in a more general setup. In a case study we measure the model risk that is present when hedging options on energy futures with a simplified model compared to a model that better fits the empirical returns observed in the market.

Keywords: Model risk, quadratic hedging, jump processes, energy markets

JEL Classification: C61, G11, G13

Suggested Citation

Detering, Nils, Measuring the Model Risk of Quadratic Risk Minimizing Hedging Strategies with an Application to Energy Markets (February 26, 2014). Available at SSRN: https://ssrn.com/abstract=2400670 or http://dx.doi.org/10.2139/ssrn.2400670

Nils Detering (Contact Author)

University of California, Santa Barbara (UCSB) ( email )

South Hall 5504

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