Calibration Risk for Exotic Options
Option pricing models are calibrated to market data of plain vanillas by minimization of an error functional. From the economic viewpoint, there are several possibilities to measure the error between the market and the model. These different specifications of the error give rise to different sets of calibrated model parameters and the resulting prices of exotic options vary significantly. These price differences often exceed the usual profit margin of exotic options. We provide evidence for this calibration risk in a time series of DAX implied volatility surfaces from April 2003 to March 2004. We analyze in the Heston and in the Bates model factors influencing these price differences of exotic options and finally recommend an error functional. Moreover, we determine the model risk of these two stochastic volatility models for the time series and consider its relation to calibration risk.
|Date of creation:||Jan 2006|
|Contact details of provider:|| Postal: Spandauer Str. 1,10178 Berlin|
Web page: http://sfb649.wiwi.hu-berlin.de
More information through EDIRC
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-343.
- Bates, David S, 1996. "Jumps and Stochastic Volatility: Exchange Rate Processes Implicit in Deutsche Mark Options," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 69-107.
When requesting a correction, please mention this item's handle: RePEc:hum:wpaper:sfb649dp2006-001. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (RDC-Team)
If references are entirely missing, you can add them using this form.