Model uncertainty and its impact on financial instrument cannot be ignored. The reason being unless an optimum pricing model is selected, it can give rise to several disadvantages. Few instances of the same have been mentioned in the article. Two approaches to nullify the ill effects of “model risk” have also been suggested.
When the question of evaluating a “portfolio of options” arises, there may be uncertainties with regard to the model selected for pricing the options. This may cause a “model risk”.
There have been instances In the past when owing to the selection of the wrong pricing model, the entities had to suffer losses. Two such instances are mentioned below.
Instances exemplifying model uncertainty and its impact on financial instrument:
In the year 1997, Nat West Capital Markets declared that they had suffered a loss of �50 million.
This loss may be attributed to the fact that they had opted for United Kingdom and German rate of interest options, which were “mispriced”. Also responsible was a UK trader dealing with single derivatives who had extended swaptions.
In the month of March 1997, Bank of Tokyo declared that the bank’s derivative unit based in New York had incurred losses worth $83 million. This was due to the fact that the model related to internal pricing had overvalued a swap portfolio as well as options pertaining to rates of interest in the United States of America.
Statistics have proved that as much as $5 billion was the loss incurred for adopting a faulty pricing model pertaining to derivatives (1999).
Importance of pricing models in derivative markets:
Since new quantitative methods pertaining to risk management are attracting focus and new derivative products are making their appearance in the derivative markets, mathematical models for option pricing have gained significant stand. These models help in taking vital financial decisions not only in matters related to pricing but also in matters related to derivative instrument hedging. However, just as these models are serving as vital tools in making investors and the players of the derivative markets realize the varied market risks, they have given birth to a new risk, referred to as “model risk”.
There are two distinguishable approaches, which have been adopted by economists for treating model uncertainty and its impact on financial instrument.
Bayesian Model Averaging.
Last Updated on : 1st August 2013