Quantifying the Model Risk Inherent in the Calibration and Recalibration of Option Pricing Models

Yu Feng, Ralph Rudd, Christopher Baker, Qaphela Mashalaba, Melusi Mavuso and Erik Schlogl
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Yu Feng: Finance Discipline Group, UTS Business School, University of Technology Sydney, http://www.uts.edu.au/about/uts-business-school/finance

No 395, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: We focus on two particular aspects of model risk: the inability of a chosen model to fit observed market prices at a given point in time (calibration error) and the model risk due to recalibration of model parameters (in contradiction to the model assumptions). In this context, we follow the approach of Glasserman and Xu (2014) and use relative entropy as a pre-metric in order to quantify these two sources of model risk in a common framework, and consider the trade–offs between them when choosing a model and the frequency with which to recalibrate to the market. We illustrate this approach applied to the models of Black and Scholes (1973) and Heston (1993), using option data for Apple (AAPL) and Google (GOOG). We find that recalibrating a model more frequently simply shifts model risk from one type to another, without any substantial reduction of aggregate model risk. Furthermore, moving to a more complicated stochastic model is seen to be counterproductive if one requires a high degree of robustness, for example as quantified by a 99% quantile of aggregate model risk.

Pages: 17 pages
Date: 2018-10-01
New Economics Papers: this item is included in nep-rmg
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Citations: View citations in EconPapers (2)

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Related works:
Journal Article: Quantifying the Model Risk Inherent in the Calibration and Recalibration of Option Pricing Models (2021)
Working Paper: Quantifying the Model Risk Inherent in the Calibration and Recalibration of Option Pricing Models (2018)
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