Optimal approximation model and decision making with model risk in options markets

Providing an analytical approach to minimize risk to a situation that traders deal with model risk, as a financial risk arises by choosing an approximation model, for the underlying securities status in financial estimates.

Improving the standard binomial pricing model and using the equivalence portfolio mechanism in a particular incomplete market situation which traders are uncertain about the actual status space of the stock binomial process.

From a research aspect, a model of approximation was provided and generalized with different hypotheses that minimizes the risk of the model for pricing call options. From an applied practical aspect, the results give to financial institutions the outlook to predict a mechanism to moderate excessive volatilities in the markets related to options.

Originality/Value:

 The study of the model risk is performed by maintaining the simple framework and elegance of the binomial model and then it is proved that by defining the optimality in the sense of minimum mean-square errors, the choice of an optimal approximation model is possible. In addition, the implementation and efficiency of the method for the multi-period model are explained.