A_METHODOLOGY_FOR_ASSESSING_MODEL_RISK_AND_ITS_APPLICATION_TO_THE_IMPLIED_VOLATILITY_FUNCTI

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1、AMETHODOLOGYFORASSESSINGMODELRISKANDITSAPPLICATIONTOTHEIMPLIEDVOLATILITYFUNCTIONMODELJohnHullandWulinSuo£JosephL.RotmanSchoolofManagementUniversityofToronto105StGeorgeStreetToronto,OntarioM5S3E6CanadaTel:(416)9788615(Hull)Fax:(416)9713048(Hull)e-mails:hull@rotman.

2、utoronto.ca;wsuo@business.queensu.caFirstVersion:May,2000;ThisVersion:Nov20001AMETHODOLOGYFORASSESSINGMODELRISKANDITSAPPLICATIONTOTHEIMPLIEDVOLATILITYFUNCTIONMODELAbstractWeproposeamethodologyforassessingmodelriskandapplyittotheimpliedvolatil-ityfunction(IVF)model

3、.Thisisapopularmodelamongtradersforvaluingexoticoptions.OurresearchisdiÞerentfromothertestsoftheIVFmodelinthatwereàectthetraders'practiceofrecalibratingthemodeldaily,orevenmorefrequently,tothemarketpricesofvanillaoptions.WeßndlittleevidenceofmodelriskwhentheIVFmod

4、elisusedtopriceandhedgecompoundoptions.However,thereissignißcantmodelriskwhenitisusedtopriceandhedgesomebarrieroptions.2I.IntroductionInthe1980sand1990swehaveseenaremarkablegrowthinboththevolumeandthevarietyofthecontractsthataretradedintheover-the-counterderivativ

5、esmarket.Banksandotherßnancialinstitutionsrelyonmathematicalmodelsforpricingandmarkingtomarketthesecontracts.AsaresulttheyhavebecomeincreasinglyexposedtowhatistermedÕmodelriskÔ.Thisistheriskarisingfromtheuseofaninadequatemodel.Somelargeßnancialinstitutionscurrentl

6、ysetasidereservesformodelrisk.Thismeansthattheydeferrecognitionofpartoftheirtradingproßtswhentheproßtsareconsideredtobedependentonthepricingmodelused.Bankregulatorscurrentlyrequirebankstoholdcapitalformarketriskandcreditrisk.TheBaselCommitteeonBankingSupervisionha

7、sindicatedthatitintendstoexpandthescopeofthecurrentcapitaladequacyframeworksothatitmorefullycapturestheriskstowhichabankisexposed.1Inparticular,itplanstorequirecapitalforoperationalrisk,oneimportantcomponentofwhichismodelrisk.AstheBaselCommitteemovestowardsimpleme

8、ntingitsproposednewframework,banksarelikelytocomeunderincreasingpressuretoidentifyandquantifymodelrisk.AspointedoutbyGreenandFiglewski(1999),aninadequat