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Handling model risk with XVAs

Author

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  • Cyril B'en'ezet

    (LaMME, ENSIIE)

  • St'ephane Cr'epey

    (LPSM)

Abstract

In this paper we revisit Burnett (2021) \& Burnett and Williams (2021)'s notion of hedging valuation adjustment (HVA), originally intended to deal with dynamic hedging frictions such as transaction costs, in the direction of model risk. The corresponding HVA reconciles a global fair valuation model with the local models used by the different desks of the bank. Model risk and dynamic hedging frictions indeed deserve a reserve, but a risk-adjusted one, so not only an HVA, but also a contribution to the KVA of the bank. The orders of magnitude of the effects involved suggest that local models should not so much be managed via reserves, as excluded altogether.

Suggested Citation

  • Cyril B'en'ezet & St'ephane Cr'epey, 2022. "Handling model risk with XVAs," Papers 2205.11834, arXiv.org, revised Aug 2024.
    • Handle: RePEc:arx:papers:2205.11834
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    References listed on IDEAS

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    1. Nicole El Karoui & Monique Jeanblanc‐Picquè & Steven E. Shreve, 1998. "Robustness of the Black and Scholes Formula," Mathematical Finance, Wiley Blackwell, vol. 8(2), pages 93-126, April.
    2. Lorenzo Silotto & Marco Scaringi & Marco Bianchetti, 2021. "Everything You Always Wanted to Know About XVA Model Risk but Were Afraid to Ask," Papers 2107.10377, arXiv.org.
    3. Rama Cont, 2006. "Model Uncertainty And Its Impact On The Pricing Of Derivative Instruments," Mathematical Finance, Wiley Blackwell, vol. 16(3), pages 519-547, July.
    4. Farkas, Walter & Fringuellotti, Fulvia & Tunaru, Radu, 2020. "A cost-benefit analysis of capital requirements adjusted for model risk," Journal of Corporate Finance, Elsevier, vol. 65(C).
    5. Claudio Albanese & Stéphane Crépey & Rodney Hoskinson & Bouazza Saadeddine, 2021. "XVA analysis from the balance sheet," Quantitative Finance, Taylor & Francis Journals, vol. 21(1), pages 99-123, January.
    6. Yuri Kabanov, 2009. "Markets with Transaction Costs. Mathematical Theory," Post-Print hal-00488168, HAL.
    7. Nils Detering & Natalie Packham, 2016. "Model risk of contingent claims," Quantitative Finance, Taylor & Francis Journals, vol. 16(9), pages 1357-1374, September.
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    9. Rama Cont, 2006. "Model uncertainty and its impact on the pricing of derivative instruments," Post-Print halshs-00002695, HAL.
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    Cited by:

    1. Cyril Bénézet & Stéphane Crépey & Dounia Essaket, 2023. "Hedging Valuation Adjustment for Callable Claims," Working Papers hal-04057045, HAL.
    2. Cyril B'en'ezet & St'ephane Cr'epey & Dounia Essaket, 2023. "Hedging Valuation Adjustment for Callable Claims," Papers 2304.02479, arXiv.org.

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