Model Uncertainty and its Impact on the Pricing of Derivative Instruments

Finance Concepts Working Paper FC-04-02

35 Pages Posted: 9 Jul 2004

See all articles by Rama Cont

Rama Cont

University of Oxford; CNRS

Date Written: June 2004

Abstract

Uncertainty on the choice of an option pricing model can lead to "model risk" in the valuation of portfolios of options. After discussing some properties which a quantitative measure of model uncertainty should verify in order to be useful and relevant in the context of risk management of derivative instruments, we introduce a quantitative framework for measuring model uncertainty in the context of derivative pricing. Two methods are proposed: the first method is based on a coherent risk measure compatible with market prices of derivatives, while the second method is based on a convex risk measure. Our measures of model risk lead to a premium for model uncertainty which is comparable to other risk measures and compatible with observations of market prices of a set of benchmark derivatives. Finally, we discuss some implications for the management of "model risk."

Keywords: model uncertainty, Knightian uncertainty, option pricing, model risk, coherent risk measures, convex risk measures

JEL Classification: G13

Suggested Citation

Cont, Rama, Model Uncertainty and its Impact on the Pricing of Derivative Instruments (June 2004). Finance Concepts Working Paper FC-04-02. Available at SSRN: https://ssrn.com/abstract=562721 or http://dx.doi.org/10.2139/ssrn.562721

Rama Cont (Contact Author)

University of Oxford ( email )

Mathematical Institute
Oxford, OX2 6GG
United Kingdom

HOME PAGE: http://https://www.maths.ox.ac.uk/people/rama.cont

CNRS ( email )

LPSM
Sorbonne University
Paris
France

HOME PAGE: http://rama.cont.perso.math.cnrs.fr/

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