Advances in Risk Management

196 MODEL RISK AND FINANCIAL DERIVATIVES pricing model for options.^3 This implied volatility figure can then be used as an inpu ...

FRANÇOIS-SERGE LHABITAN T 197 30 25 20 15 10 130 120 110 100 90 80 70 5 Years 2 Years 1 Years 6 Months 2 Months Time to maturity ...

198 MODEL RISK AND FINANCIAL DERIVATIVES of information in a few standardized and comparable numbers. This is the case, for inst ...

FRANÇOIS-SERGE LHABITAN T 199 of course, the most likely candidates to generate model risk, since common sense is of little use. ...

200 MODEL RISK AND FINANCIAL DERIVATIVES inevitably carry their drawbacks. They produce discontinuities, which can be inherent n ...

FRANÇOIS-SERGE LHABITAN T 201 hypotheses of the model may simply not hold true in the real world, result- ing in a model that pe ...

202 MODEL RISK AND FINANCIAL DERIVATIVES Now, in reality, the trader does not know perfectly equation (10.1), and may therefore ...

FRANÇOIS-SERGE LHABITAN T 203 between the drift of the underlying asset and the risk-free rate. Depend- ing on the sign of these ...

204 MODEL RISK AND FINANCIAL DERIVATIVES Rule 1: Define what should be a good model Before qualifying a model as being better th ...

FRANÇOIS-SERGE LHABITAN T 205 developed, there is a tendency to either quickly adapt an older model with or without authorized m ...

206 MODEL RISK AND FINANCIAL DERIVATIVES It is important to realize that the role of model testing should not be reduced to vali ...

FRANÇOIS-SERGE LHABITAN T 207 model risk source (the mark to model syndrome). If the benchmark model is wrong, everything can go ...

208 MODEL RISK AND FINANCIAL DERIVATIVES understanding of risks, the creation of new financial products, and, there- fore, the n ...

FRANÇOIS-SERGE LHABITAN T 209 Rule 8: Use a model for what it is made for Most models were initially created for a specific purp ...

210 MODEL RISK AND FINANCIAL DERIVATIVES issues; Bermudian options create modeling problems due to their hybrid nature between A ...

FRANÇOIS-SERGE LHABITAN T 211 thoseoutputs. Inalltherecentderivativeslosses, managementcanbefaulted for a lack of understanding ...

212 MODEL RISK AND FINANCIAL DERIVATIVES Gibson, R., Lhabitant, F.S., Pistre, N. and Talay, D. (1999). “Interest Rate Model Risk ...

CHAPTER 11 Evaluating Value-at-Risk Estimates: A Cross-Section Approach Raffaele Zenti, Massimiliano Pallotta and Claudio Marsal ...

214 EVALUATING VALUE-AT-RISK ESTIMATES: A CROSS-SECTION APPROACH propose a methodology based on cross-section analysis of random ...

RAFFAELE ZENTI, MASSIMILIANO PALLOTTA AND CLAUDIO MARSALA 215 Unconditional coverage property A given modeljsatisfies this prope ...