Model Risk in Options Pricing

Model risk occurs when the mathematical formulas used to price options or manage risk are based on flawed assumptions about how the market operates. Traders often use models like Black-Scholes, which assume constant volatility and normal distribution of returns, to calculate the fair value of a derivative.

In reality, crypto markets exhibit fat tails and sudden volatility spikes that these models do not adequately capture. If a trader relies too heavily on these models, they may underprice risk or fail to hedge against extreme events.

This risk is exacerbated when market participants behave strategically against the model, exploiting its weaknesses. Model risk is essentially the gap between the theoretical value produced by a formula and the actual price dictated by market microstructure.

It represents the danger of trusting a simplified representation of a complex, unpredictable financial system. When the model breaks down, the financial consequences for portfolios can be severe.