A METHODOLOGY FOR ASSESSING MODEL RISK AND ITS
APPLICATION TO THE IMPLIED VOLATILITY FUNCTION MODEL

Abstract

We propose a methodology for assessing model risk and apply it to the implied volatil-
ity function (IVF) model. This is a popular model among traders for valuing exotic options.
Our research is diÞerent from other tests of the IVF model in that we reàect the traders'
practice of using the model for the relative pricing of exotic and plain vanilla options at
one point in time. We ßnd little evidence of model risk when the IVF model is used to
price and hedge compound options. However, there is signißcant model risk when it is
used to price and hedge some barrier options.