Data Management

Applying Hedging Strategies To Estimate Model Risk And Provision Calculation

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Executive Summary

This paper introduces a new model risk measure based on hedging strategies to estimate model risk and provision calculation under uncertainty of volatility. This measure allows comparing different products and models (pricing hypothesis) under a homogeneous framework and conclude which one is the best. The model risk measure is defined in terms of the expected value and standard deviation of the loss given by the hedging strategy at a given time horizon. It has been assumed that the market volatility surface is driven by Heston's dynamics calibrated to market for a given time horizon. The method is applied to estimate and compare model risk under volga-vanna and Black-Scholes models for double-no-touch options and a porfolio of forward fader options.

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