Specification Tests of Calibrated Option Pricing Models
In spite of the popularity of model calibration in finance, empirical researchers have put more emphasis on model estimation than on the equally important goodness-of-fit problem.This is due partly to the ignorance of modelers, and more to the ability of existing statistical tests to detect specification errors. In practice, models are often calibrated by minimizing a loss function of the differences between the modelled and actual observations. Under this approach, it is challenging to disentangle model error from estimation error in the residual series. To circumvent the difficulty, we study an alternative way of estimating the model by exact calibration. Unlike the error minimization approach, all information about dynamic misspecifications is channeled to the parameter estimation residuals under exact calibration.In the context of option pricing, we illustrate that standard time series tests are powerful in detecting various kinds of dynamic misspecifications. Compared to the error minimization approach, exact calibration yields more reasonable model comparison result, and delivers more accurate hedging performance that is robust to both gradual and abrupt structural shifts of state variables.
|Date of creation:||May 2013|
|Date of revision:||Dec 2014|
|Contact details of provider:|| Postal: |
Phone: 61 +2 9351 5055
Fax: 61 +2 9351 4341
Web page: http://sydney.edu.au/arts/economics
More information through EDIRC
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.:
- Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
- Vuong, Quang H, 1989. "Likelihood Ratio Tests for Model Selection and Non-nested Hypotheses," Econometrica, Econometric Society, vol. 57(2), pages 307-33, March.
- Bates, David S., 2000. "Post-'87 crash fears in the S&P 500 futures option market," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 181-238.
- repec:oup:restud:v:72:y:2005:i:2:p:499-541 is not listed on IDEAS
- Douglas Rivers & Quang Vuong, 2002. "Model selection tests for nonlinear dynamic models," Econometrics Journal, Royal Economic Society, vol. 5(1), pages 1-39, June.
- Pan, Jun, 2002. "The jump-risk premia implicit in options: evidence from an integrated time-series study," Journal of Financial Economics, Elsevier, vol. 63(1), pages 3-50, January.
- Hong, Yongmiao & Lee, Yoon-Jin, 2007. "An Improved Generalized Spectral Test For Conditional Mean Models In Time Series With Conditional Heteroskedasticity Of Unknown Form," Econometric Theory, Cambridge University Press, vol. 23(01), pages 106-154, February.
- Heston, Steven L & Nandi, Saikat, 2000. "A Closed-Form GARCH Option Valuation Model," Review of Financial Studies, Society for Financial Studies, vol. 13(3), pages 585-625.
When requesting a correction, please mention this item's handle: RePEc:syd:wpaper:2123/9191. 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: (Vanessa Holcombe)
If references are entirely missing, you can add them using this form.