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MODEL UNCERTAINTY AND ITS IMPACT ON THE PRICING OF DERIVATIVE INSTRUMENTS
Author(s) -
Cont Rama
Publication year - 2006
Publication title -
mathematical finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.98
H-Index - 81
eISSN - 1467-9965
pISSN - 0960-1627
DOI - 10.1111/j.1467-9965.2006.00281.x
Subject(s) - risk neutral measure , econometrics , model risk , derivative (finance) , context (archaeology) , valuation (finance) , risk management , economics , measure (data warehouse) , valuation of options , risk measure , benchmark (surveying) , risk premium , market risk , computer science , actuarial science , financial economics , finance , data mining , portfolio , paleontology , geodesy , biology , geography
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.”