Model Risk Adjusted Hedge Ratios
27 Pages Posted: 9 May 2010
Date Written: March 3, 2009
Abstract
Most option pricing models assume all parameters except volatility are fixed; yet they almost invariably change on re-calibration. This paper explains how to capture the model risk that arises when parameters that are assumed constant have calibrated values that change over time and how to use this model risk to adjust the price hedge ratios of the model. Empirical results demonstrate an improvement in hedging performance after the model risk adjustment.
Keywords: delta hedge, model risk
JEL Classification: G1
Suggested Citation: Suggested Citation
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