Hedge backtesting for model validation

Derivatives pricing and expected exposure models must be backtested as a basic regulatory requirement. But what does this mean exactly, and how can it be used to reserve against model risk? Lee Jackson introduces a general backtesting framework for market-calibrated models, making the link with financial theory, and shows how it can inform recalibration and help insulate banks from model failure

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Pricing and hedging is easy, in theory. The existence of arbitrage-free prices is equivalent to the existence of martingale measures, and there are ways of constructing replication strategies via the martingale representation theorem and the Clark-Ocone formula (see, for example, Harrison & Pliska, 1981, and Musiela & Rutkowski, 2005). Arbitrage-free prices can also be obtained as solutions to certain partial differential equations (PDEs) (see, for example, Harrison & Pliska, 1981, and Black &

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