Worst case model risk management (Q1424697): Difference between revisions

The authors describe the financial strategy which a trader can follow in order to manage the model risk. Instead of supposing that the trader knows the exact model followed by the real market it is assumed that the trader knows that the correct model of the market belongs to a wide class of admissible models. The trade chooses trading strategies from a set of admissible strategies to decrease the risk and therefore acts as a minimizer of the risk. On the other hand it is supposed that the market systematically acts against the interest of the trader, so that it acts as a maximizer of the risk. Thus the model risk control problem is considered as a two players (Trader versus Market) zero-sum stochastic differential game problem and the corresponding strategies. Therefore this construction corresponds to a `worst case' worry and, in this sense, can be viewed as a continuous-time extension of discrete-time strategies based upon prescriptions issued from VaR analyses at the beginning of each period. In addition, the initial value of the optimal portfolio can be seen as the minimal amount of money which is needed to face the worst possible damage. A proper mathematical statement for such a game problem is given. It is proved that the value function of this game problem is the unique viscosity solution to an Hamilton-Jacobi-Bellman-Isaacs equation, and satisfies the Dynamic Programming Principle. This article is deeply related to the article by \textit{J. Cvitanić} and \textit{I. Karatzas} [Finance Stoch. 3, No. 4, 451-482 (1999; Zbl 0982.91030)]. It gives an answer to a part of open problems listed in the Conclusion of the mentioned article.