Model Risk Measurement Under Wasserstein Distance

41 Pages Posted: 5 Oct 2018

See all articles by Yu Feng

Yu Feng

University of Technology Sydney (UTS) - Faculty of Business

Erik Schlögl

University of Technology Sydney (UTS), Quantitative Finance Research Centre; University of Cape Town (UCT) - The African Institute of Financial Markets and Risk Management; Faculty of Science, Department of Statistics, University of Johannesburg; Financial Research Network (FIRN)

Date Written: September 11, 2018

Abstract

The paper proposes a new approach to model risk measurement based on the Wasserstein distance between two probability measures. It formulates the theoretical motivation resulting from the interpretation of fictitious adversary of robust risk management. The proposed approach accounts for all alternative models and incorporates the economic reality of the fictitious adversary. It provides practically feasible results that overcome the restriction and the integrability issue imposed by the nominal model. The Wasserstein approach suits for all types of model risk problems, ranging from the single-asset hedging risk problem to the multi-asset allocation problem. The robust capital allocation line, accounting for the correlation risk, is not achievable with other non-parametric approaches.

Keywords: Model Risk, Wasserstein Metric, Robust Modelling, Volatility Risk, Portfolio Optimisation, Option Hedging

JEL Classification: G11, G13, C10

Suggested Citation

Feng, Yu and Schloegl, Erik, Model Risk Measurement Under Wasserstein Distance (September 11, 2018). FIRN Research Paper, Available at SSRN: https://ssrn.com/abstract=3248825 or http://dx.doi.org/10.2139/ssrn.3248825

Yu Feng

University of Technology Sydney (UTS) - Faculty of Business ( email )

Australia

Erik Schloegl (Contact Author)

University of Technology Sydney (UTS), Quantitative Finance Research Centre ( email )

Ultimo
PO Box 123
Sydney, NSW 2007
Australia
+61 2 9514 2535 (Phone)

HOME PAGE: http://www.schlogl.com

University of Cape Town (UCT) - The African Institute of Financial Markets and Risk Management ( email )

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Rondebosch
Cape Town, Western Cape 7700
South Africa

Faculty of Science, Department of Statistics, University of Johannesburg ( email )

Auckland Park, 2006
South Africa

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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