An Investigation of Model Risk in a Market with Jumps and Stochastic Volatility

European Journal of Operational Research, Volume 253, Issue 3, September 2016, Pages 648-658

41 Pages Posted: 2 Aug 2014 Last revised: 4 Dec 2016

Date Written: September 2016

Abstract

The aim of this paper is to investigate model risk aspects of variance swaps and forward start options in a realistic market setup where the underlying asset price process exhibits stochastic volatility and jumps. We devise a general framework in order to provide evidence of the model uncertainty attached to variance swaps even when the popular replication result is accounted for. Then, we consider the model risk of forward-start options and we show how this risk can be reduced by adding variance swaps in the set of calibration instruments. In the adopted framework, variance swaps and forward-start options can be valued by means of analytic methods. We measure model risk using a set of 21 models representing various dynamics with both continuous and discontinuous sample paths. To conduct our empirical analysis, we work with two major equity indices (S&P 500 and Eurostoxx 50) under different market situations.

Keywords: Risk Management, Model Risk, Robustness and Sensitivity Analysis, Variance Swap, Forward-start option

JEL Classification: D81, C52, G13

Suggested Citation

Coqueret, Guillaume and Tavin, Bertrand, An Investigation of Model Risk in a Market with Jumps and Stochastic Volatility (September 2016). European Journal of Operational Research, Volume 253, Issue 3, September 2016, Pages 648-658, Available at SSRN: https://ssrn.com/abstract=2474223 or http://dx.doi.org/10.2139/ssrn.2474223

Guillaume Coqueret

EMLYON Business School ( email )

23 Avenue Guy de Collongue
Ecully, 69132
France

Bertrand Tavin (Contact Author)

emlyon business school ( email )

23 Avenue Guy de Collongue
Ecully, 69132
France

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