Scenario-Based Evaluation and Uncertainty

Abstract

The following problems arise in practice:

• A concrete instance of the selected equity, FX or interest rate model must be chosen, by instantiating its volatility and other coefficients with plausi- ble values. For example, the Black-Scholes model dS=μS _t +∂dW might be instantiated to dS = 0.05 S _t + 0.3 dW.

• Once instantiated, models often prove too weak to represent the market dynamics adequately; in the case of Black-Scholes, this deficiency shows itself in the often cited implied volatility smile.