Market risk and model risk for a financial institution writing options

Derivatives valuation and risk management involve heavy use of quantitative models. To develop a quantitative assessment of model risk as it affects t he basic option writing strategy that might be followed by a financial inst itution, we conduct an empirical simulation, with and without hedging, usin g data from 1976 to 1996. Results indicate that imperfect models and inaccu rate volatility forecasts create sizable risk exposure for option writers. We consider to what extent the damage due to model risk can be limited by p ricing options using a higher volatility than the best estimate from histor ical data.