How Does the Concept of “Model Risk” Contribute to the Wider Spreads of Exotic Options?

Model risk is the risk of losses due to the inaccuracy of the financial model used to price and hedge a derivative. Exotic options require more complex pricing models (beyond BSM), which rely on more assumptions and inputs.

The uncertainty and potential error in these complex models increase the market maker's risk. To compensate for this higher model risk, market makers quote wider bid-ask spreads, which directly translates to higher slippage for the trader.