Minimum-Relative-Entropy Calibration of Asset-Pricing Models

Marco Avellaneda
Additional contact information
Marco Avellaneda: Courant Institute of Mathematical Sciences, New York University, 251 Mercer Street, New York, NY, 10012, USA

International Journal of Theoretical and Applied Finance (IJTAF), 1998, vol. 01, issue 04, 447-472

Abstract: We present an algorithm for calibrating asset-pricing models to the prices of benchmark securities. The algorithm computes the probability that minimizes the relative entropy with respect to a prior distribution and satisfies a finite number of moment constraints. These constraints arise from fitting the model to the prices of benchmark prices are studied in detail. We find that the sensitivities can be interpreted as regression coefficients of the payoffs of contingent claims on the set of payoffs of the benchmark instruments. We show that the algorithm has a unique solution which is stable, i.e. it depends smoothly on the input prices. The sensitivities of the values of contingent claims with respect to varriations in the benchmark instruments, in the risk-neutral measure. We also show that the minimum-relative-entropy algorithm is a special case of a general class of algorithms for calibrating models based on stochastic control and convex optimization. As an illustration, we use minimum-relative-entropy to construct a smooth curve of instantaneous forward rates from US LIBOR swap/FRA data and to study the corresponding sensitivities of fixed-income securities to variations in input prices.

Date: 1998
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (28)

Downloads: (external link)
http://www.worldscientific.com/doi/abs/10.1142/S0219024998000242
Access to full text is restricted to subscribers

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:wsi:ijtafx:v:01:y:1998:i:04:n:s0219024998000242

Ordering information: This journal article can be ordered from

DOI: 10.1142/S0219024998000242

Access Statistics for this article

International Journal of Theoretical and Applied Finance (IJTAF) is currently edited by L P Hughston

More articles in International Journal of Theoretical and Applied Finance (IJTAF) from World Scientific Publishing Co. Pte. Ltd.
Bibliographic data for series maintained by Tai Tone Lim ().