Banking And Finance

Market Risk and Model Risk For a Financial Institution Writing Options

---

Trading in derivatives involves heavy use of quantitative models for valuation and risk
management. These models are necessarily imperfect, and when options are involved, the models
require a volatility input that must be forecasted, subject to error. This creates “model risk” to
which nearly all participants in derivatives markets are exposed. In this paper, we conduct an
empirical simulation, with and without hedging, using historical data from 1976-1996 for several
important markets. The object is to develop a quantitative assessment of the extent to which the
different sources of model risk can be expected to affect the kind of basic option writing strategy
that might be followed by a bank or another financial institution. Specifically, we explore the
following problem: If a bank or a similar financial institution writes standard European calls and
puts and prices them using the appropriate variant of the Black-Scholes model with a volatility
forecast computed optimally from historical data, what are the risk and return characteristics of
the trade? More generally, what is the market and model risk exposure faced by a bank that does
this transaction repeatedly over time? The results indicate that pricing and hedging errors due to
imperfect models and inaccurate volatility forecasts create sizable risk exposure for option
writers. We then consider to what extent the bank can limit the damage due to model risk by
pricing options using a higher volatility than its best estimate from historical data.

---

Availability

No copy data

Detail Information

Series Title

-

Call Number

-

Publisher

: .,

Collation

-

Language

English

ISBN/ISSN

-

Classification

NONE

Content Type

-

Media Type

-

Carrier Type

-

Edition

-

Subject(s)

Market Risk and Model Risk For a Financial Institu

Specific Detail Info

-

Statement of Responsibility

-

Other version/related

File Attachment

Comments

---

You must be logged in to post a comment