Model risk adjusted hedge ratios |
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| Authors: | Carol Alexander Andreas Kaeck Leonardo M Nogueira |
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| Institution: | 1. ICMA Centre, The University of Reading, Berkshire, UK;2. Banco Central do Brasil, Brazil and ICMA Centre, The University of Reading, Berkshire, UK |
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| Abstract: | Most option pricing models assume all parameters except volatility are fixed; yet they almost invariably change on re‐calibration. This article 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. © 2009 Wiley Periodicals, Inc. Jrl Fut Mark 29:1021–1049, 2009 |
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