Question

Suppose that a financial institution uses a imprecise model for pricing and hedging a particular type of structured product Discuss how, if at all, it is likely to realize its mistake.

Answer 1

If the bank/financial institution uses a imprecise model for pricing and hedging a particular type of structured product, and the pricing of its product is high when compared with other market participants, the bank/financial institution may realize its mistake in the following two scenarios:

a) when other market participants offer to sell the product to the bank/financial institution (because of higher pricing)

or

b) when the bank/financial institution is in the process of closing all or some of its positions.

The mistake may, however, never be realized in the following situations:

a) if the other market participants are using the same methodology for pricing the product as the bank/financial institution

or

b) if the bank has limited exposure/interaction with other market participants with respect to product pricing.

Practically, it would not be possible to identify the losses that may be suffered by the bank/financial institution because perfect hedging can never be achieved. Further, it would not be easy to detect the mistake/mispricing if the structured product is not traded on a frequent basis.