A comprehensive testing framework for financial products
Confidence that pricing is correctly, reliably and efficiently performed can only be achieved through a comprehensive testing framework. Testing new product pricing models for plausibility is not enough to guarantee that pricing is correct.
Sound pricing requires a focused and structured testing framework including:
- A thorough examination of all parameters required for each model.
- Demonstration of the limitations of the model and numerical methods applied.
- Determination of the calculation speed and precision trade off.
- Regular testing of IT systems and data inputs for systematic errors.
- Stress-testing of the model and parameters including extreme market conditions.
Much more can be gained through implementing a sound testing framework than just promoting good risk management:
- Assure price quality
- Identify risky product behaviour
- Uncover systematic pricing errors
- Understand modelling weaknesses and limitations
- Describe precision and efficiency trade-off
- Safely introduce new products
- Avoid costs, including reputation risk, from miss-pricing
- Support active hedging strategies
- Provide pricing quality even in instable market conditions