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.