Applying hedging strategies to estimate model risk and provision calculation

This paper introduces a relative model risk measure of a product priced with a given model, with respect to another reference model by which the market is assumed to be driven. This measure allows a comparison of products valued with different models (pricing hypothesis) under a homogeneous framework. This allows comparing models with respect to the reference which should be chosen to be a market benchmark. The relative model risk measure is defined as the expected shortfall of the hedging strategy at a given time horizon for a chosen significance level. The reference model has been chosen to be Heston’s calibrated to market for a given time horizon. The method is applied to estimate and compare this relative model risk measure under volga--vanna and Black--Scholes models for double-no-touch options and a portfolio of forward fader options.