Journal of Finance and Investment Analysis

A Mathematical Model for the Pricing of Derivative Financial Products: the Role of the Banking Supervision and of the Model Risk

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• Abstract

   

  This paper aims to identify an innovative procedure to assess the model risk of a derivative financial product. More precisely, the authors, after briefly discussing the role of banking supervision, present a framework to estimate the model risk at the current time of a bond and they distinguish its systematic component. This model, consisting of two different expressions of the security price, is based on the hypothesis that the underlying interest rate is a swap rate that may be represented also as an AR(1)-GARCH(1,1) process. Moreover, the authors show that their model can be used for forecasting purposes.

  In reality, the aim of this study is to investigate the link between pricing models of financial derivatives and model risk and to highlight that this latter depends on the volatility of the security and on the price distribution.

   

  JEL classification numbers: C02, C60, G17, G20.

  Keywords: Model risk, Pricing model, Reverse Floater, Financial derivatives, Banking supervision.