Model Risk and Model Choice in the Case of Barrier Options

48 Pages Posted: 11 Mar 2018 Last revised: 26 Jan 2019

See all articles by Rainer Baule

Rainer Baule

University of Hagen

David Shkel

Fernuniversität in Hagen - University of Hagen

Date Written: March 11, 2018

Abstract

We analyze model risk for the pricing of barrier options. In contrast to existing literature, this paper is based on an empirical data set of over 40,000 bonus certificates to analyze the real market extent of model risk for traded barrier options instead of purely synthetic options. For this purpose a local volatility model, the Heston model and the Bates model are applied. Furthermore, we add to the literature on the behavior of issuers of retail derivatives in terms of model choice. We find evidence that the majority of the issuers prefer stochastic volatility over local volatility models, while they do not use the even more realistic Bates model which incorporates jumps in the underlying.

Keywords: Model Risk, Heston Model, Bates Model, Local Volatility, Bonus Certificates, Barrier Options, Empirical Finance, Retail Derivatives

JEL Classification: C61, C63, G12, G13

Suggested Citation

Baule, Rainer and Shkel, David, Model Risk and Model Choice in the Case of Barrier Options (March 11, 2018). Available at SSRN: https://ssrn.com/abstract=3138159 or http://dx.doi.org/10.2139/ssrn.3138159

Rainer Baule

University of Hagen ( email )

Universitaetsstrasse 41
Hagen, 58097
Germany

David Shkel (Contact Author)

Fernuniversität in Hagen - University of Hagen ( email )

Universitätsstr. 41
Chair of Banking and Finance
Hagen, 58084
Germany

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