A comprehensive testing framework for financial products
Just as bees building a beehive rely on each honey comb to provide a stable base for the next, a well formed testing structure can be developed if each test builds on the tests performed before it. Furthermore, the rewards of developing a proper testing structure far exceed fulfilling risk management requirements.
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 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, such as low market liquidity.
Much more can be gained through implementing a sound testing framework than just promoting good risk management.
- Price quality assurance
- Identification of risky product behavior
- Uncover systematic pricing errors
- Understand modeling weaknesses and limitations
- Describe precision and efficiency tradeoff
- Safely introduce new products
- Key for sound risk management
- Avoid costs, including reputation risk, from mis-pricing
- Support active hedging strategies
- Provide pricing quality even in instable market conditions.
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