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

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 &