Quantifying Model Performance

20 Pages Posted: 19 Dec 2018 Last revised: 31 Mar 2019

See all articles by Alexandre Antonov

Alexandre Antonov

Abu Dhabi Investment Authority; ADIA

Jan F. Baldeaux

Standard Chartered Bank

Rajiv Sesodia

Standard Chartered Bank

Date Written: March 29, 2019

Abstract

A model/hedging performance is relatively poorly covered in the literature. This is particularly valid for general portfolios including both vanilla and exotic instruments. Practitioners generally use so called \pnl explain which measures whether portfolio price movements can be explained by changes in risk factors for corresponding sensitivities. It gives, however, relatively little information about the model performance. In this paper, we address the problem under a new angle of the payoff replication along the whole portfolio life and come up with a metric which can classify different hedging strategies, in both relative and absolute ways.

We confirm our theoretical results with numerical experiments. Initially we generate scenarios using the Heston model: the obtained numerical classification of different hedging strategies naturally agrees with a common sense. Moreover, this classification remains valid for all the Heston evolution scenarios (Monte Carlo paths) with tiny exceptions. Subsequently, we repeat these tests using real market data. Contrary to previous finding in the literature, we conclude that more sophisticated models, such as the Heston model, do in fact outperform simpler models, such as the Black-Scholes model, according to the metric introduced in this paper. These results contradict previous findings in the literature, so we supplement our numerical tests with the corresponding P\&L explained results. In accordance with the literature, the latter metric cannot identify more sophisticated models as performing better than simple models, however the metric introduced in this paper can.

Keywords: hedging performance, model performance, payoff replication, model risk, P&L explain

JEL Classification: C1, C3, C5, C6, E43, G12, G13

Suggested Citation

Antonov, Alexandre and Baldeaux, Jan F. and Sesodia, Rajiv, Quantifying Model Performance (March 29, 2019). Available at SSRN: https://ssrn.com/abstract=3299615 or http://dx.doi.org/10.2139/ssrn.3299615

Alexandre Antonov (Contact Author)

Abu Dhabi Investment Authority ( email )

211 Corniche Road
Abu Dhabi, Abu Dhabi PO Box3600
United Arab Emirates

ADIA ( email )

211 Corniche
abu Dhabi
United Arab Emirates

Jan F. Baldeaux

Standard Chartered Bank ( email )

United States

Rajiv Sesodia

Standard Chartered Bank ( email )

United States

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