From Black-Scholes to Heston, the models used to price structured products can materially change both valuation and hedging exposures. A Reverse Convertible illustrates how volatility assumptions can reshape the price and Greeks of a seemingly simple product.
More complex structured products combine derivatives, including exotic options, priced with models that can have many parameters, each a potential source of error in the price and the issuer’s hedge. That is the raison d’être of this article, illustrated with a classic Reverse Convertible: the issue exists even with plain vanilla options. Model risk A model simplifies reality for a given purpose, so every model carries model risk, a form of operational risk. It stems from inp