| Summary: | 碩士 === 淡江大學 === 財務金融學系 === 88 === Derivatives valuation and risk management involves heavy use of quantitative models. But models are imperfect, and option models also require a volatility forecast, that is subject to error. This creates model risk to which nearly all participants in derivatives markets are exposed. To develop a quantitative assessment of model risk and market risk as it affects the kind of basic option writing strategy that might be followed by a bank or another financial institution, this study follows the research of Figlewski and Green (1999), and conducts an empirical simulation, with and without hedging, using historical data from 1971-1998 for Taiwan stock market. Specifically, we examine the risk and return characteristics of writing European calls and puts, pricing and hedging them using the Black-Scholes model with volatility forecasts computed optimally from historical data. The results indicate that imperfect models and inaccurate volatility forecasts create sizable risk exposure for option writers. We then consider to what extent the bank can limit the damage due to model risk and market risk by pricing options using a higher volatility than its best estimate from historical data.
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