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A Methodology for Assessing Model Risk and its Application to the Implied Volatility Function Model

Published online by Cambridge University Press:  06 April 2009

John Hull  and
Wulin Suo
John Hull
Affiliation:
[email protected], Joseph L. Rotman School of Management, University of Toronto, 105 St. George Street, Toronto, Ontario, M5S 3E6, Canada
Wulin Suo
Affiliation:
[email protected], School of Business, Queen's University, 99 University Avenue, Kingston, Ontario, K7L 3N6, Canada.
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Abstract

We propose a methodology for assessing model risk and apply it to the implied volatility function (IVF) model. This is a popular model among traders for valuing exotic options. Our research is different from other tests of the IVF model in that we reflect the traders' practice of using the model for the relative pricing of exotic and plain vanilla options at one point in time. We find little evidence of model risk when the IVF model is used to price and hedge compound options. However, there is significant model risk when it is used to price and hedge some barrier options.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 37 , Issue 2 , June 2002 , pp. 297 - 318
Copyright
Copyright © School of Business Administration, University of Washington 2002

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