Applying hedging strategies to estimate model risk and provision calculation

TL;DR

This paper proposes a relative model risk measure based on hedging strategies to compare different pricing models for financial products, using expected shortfall as a metric, with applications to options pricing.

Contribution

It introduces a novel relative model risk measure that compares models against a market-calibrated reference, enabling consistent risk assessment across different pricing hypotheses.

Findings

The measure effectively distinguishes model closeness to market behavior.

Application to options demonstrates practical differences between models.

Hedging-based risk assessment provides a robust framework for model comparison.

Abstract

This paper introduces a relative model risk measure of a product priced with a given model, with respect to another reference model for which the market is assumed to be driven. This measure allows comparing products valued with different models (pricing hypothesis) under a homogeneous framework which allows concluding which model is the closest to the reference. The relative model risk measure is defined as the expected shortfall of the hedging strategy at a given time horizon for a chosen significance level. The reference model has been chosen to be Heston calibrated to market for a given time horizon (this reference model should be chosen to be a market proxy). The method is applied to estimate and compare this relative model risk measure under volga-vanna and Black-Scholes models for double-no-touch options and a portfolio of forward fader options.