Humboldt-Universität zu Berlin - High Dimensional Nonstationary Time Series

IRTG1792DP2018 036

Model risk of contingent claims

Nils Detering
Natalie Packham

Paralleling regulatory developments, we devise value-at-risk and expected shortfall type
risk measures for the potential losses arising from using misspecied models when pricing
and hedging contingent claims. Essentially, losses from model risk correspond to losses realized
on a perfectly hedged position. Model uncertainty is expressed by a set of pricing
models, relative to which potential losses are determined. Using market data, a unied
loss distribution is attained by weighing models according to a relative likelihood criterion.
Examples demonstrate the magnitude of model risk and corresponding capital buers necessary
to suciently protect trading book positions against unexpected losses from model

Model risk, parameter uncertainty, hedge error, value-at-risk, expected shortfall

JEL Clasification:
G32, G13