The Mathematical Institute, University of Oxford, Eprints Archive

Model Uncertainty and its Impact on Derivative Pricing

Gupta, Alok and Reisinger, Christoph and Whitley, Alan Model Uncertainty and its Impact on Derivative Pricing. In: Rethinking Risk Measurement and Reporting. RISK, pp. 623-661. (In Press)

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Abstract

Financial derivatives written on an underlying can normally be priced and hedged accurately only after a suitable mathematical model for the underlying has been determined. This chapter explains the difficulties in finding a (unique) realistic model \u2014 model uncertainty. If the wrong model is chosen for pricing and hedging, unexpected and unwelcome financial consequences may occur. By wrong model we mean either the wrong model type (specification
uncertainty) or the wrong model parameter (parameter uncertainty). In both cases, the impact of model uncertainty on pricing and hedging is significant. A variety of measures are introduced to value the model uncertainty of derivatives and a numerical example again confirms that these values are a significant proportion of the derivative price.

Item Type:Book Section
Subjects:D - G > Game theory, mathematical finance, economics, social and behavioral sciences
Research Groups:Mathematical and Computational Finance Group
ID Code:939
Deposited By:Dr Alok Gupta
Deposited On:02 Sep 2010 10:53
Last Modified:02 Sep 2010 10:53

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