Measuring distribution risk in discrete models

TL;DR

This paper develops analytical and simulated bounds for payoff functions and option prices in discrete models, assessing the impact of model choice and risk-neutral measures in incomplete markets.

Contribution

It introduces new analytical bounds for European and American options and simulated bounds for perturbations of the minimal martingale measure in discrete models.

Findings

Analytical bounds for European and American option prices.

Simulated bounds for perturbations of the minimal martingale measure.

Quantifies the impact of model risk on derivative pricing.

Abstract

Model risk measures consequences of choosing a model in a class of possible alternatives. We find analytical and simulated bounds for payoff functions on classes of plausible alternatives of a given discrete model. We measure the impact of choosing a risk-neutral measure on convex derivative pricing in incomplete markets. We find analytical bounds for prices of European and American options in the class of all risk-neutral measures, and we also find simulated bounds for given classes of perturbations of the minimal martingale equivalent measure.