Incorporating parameter risk into derivatives prices - an approach to bid-ask spreads

Karl F. Bannör (Deloitte & Touche GmbH)
Thursday, June 11, 2015 - 4:00pm
TU Berlin, Straße des 17. Juni 136, 10623 Berlin, Raum MA 041

We present a new method based on convex risk measures to incorporate parameter risk (e.g. estimation and calibration risk) into derivative prices, generalizing the well-known conic finance approach. In this context, weak continuity properties of convex risk measures are discussed. As an application we calculate parameter risk-implied bid-ask spreads of exotics, enabling us to compare the parameter risk of different models and different exotics. Furthermore, we introduce a nonparametric calibration procedure to real world bid-ask prices using distortion risk measures, and obtain empirical results, both in the conic finance framework as well as employing the new method.