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Measures of Model Risk for Continuous-Time Finance Models

Author

Listed:
  • Emese Lazar
  • Shuyuan Qi
  • Radu Tunaru

Abstract

Measuring model risk is required by regulators in financial and insurance markets. We separate model risk into parameter estimation risk (PER) and model specification risk (MSR), and we propose expected shortfall type model risk measures applied to Lévy jump, affine jump-diffusion, and multifactor models. We investigate the impact of PER and MSR on the models’ ability to capture the joint dynamics of stock and option prices. Using Markov chain Monte Carlo techniques, we implement two methodologies to estimate parameters under the risk-neutral probability measure and the real-world probability measure jointly.

Suggested Citation

  • Emese Lazar & Shuyuan Qi & Radu Tunaru, 2024. "Measures of Model Risk for Continuous-Time Finance Models," Journal of Financial Econometrics, Oxford University Press, vol. 22(5), pages 1456-1481.
    • Handle: RePEc:oup:jfinec:v:22:y:2024:i:5:p:1456-1481.
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    File URL: http://hdl.handle.net/10.1093/jjfinec/nbae001
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    More about this item

    Keywords

    Lévy models; MCMC; model specification risk; parameter estimation risk; stochastic volatility;
    All these keywords.

    JEL classification:

    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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