The effects of model errors and market imperfections on financial institutions writing derivative warrants: Simulation evidence from Taiwan

Huimin Chung*, Chin Shen Lee, Soushan Wu

*Corresponding author for this work

Research output: Contribution to journalJournal Article peer-review

3 Scopus citations

Abstract

This paper uses the historical simulation approach, similar to that of Green and Figlewski [Journal of Finance 54 (1999) 1465] to investigate the effects of market imperfections and model errors on financial institutions writing derivative warrants. The paper undertakes specific exploration of the effects of particular market imperfections such as transaction costs and the primary market process. An understanding of model risk in the valuation and trading of derivative securities is particularly important for emerging markets, because asset returns are too fat-tailed to be lognormal and errors in volatility forecasts tend to be very significant. Simulation evidence shows that model risk is extremely significant for issuers of derivative warrants in emerging markets such as Taiwan. While exploring possible remedial strategies for market imperfections and model errors, simulation evidence suggests that a search for a better pricing model for the Taiwan derivative warrants market is called for.

Original languageEnglish
Pages (from-to)55-75
Number of pages21
JournalPacific Basin Finance Journal
Volume10
Issue number1
DOIs
StatePublished - 01 2002

Keywords

  • Derivative warrants
  • Market imperfections
  • Model risk
  • Up-and-out call

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