Regularization effect on model calibration

Mesias Alfeus, Xin-Jiang He and Song-Ping Zhu

Journal of Risk

Abstract: As is well known, the centerpiece of model calibration is regularization, which plays an important role in transforming an ill-posed calibration problem into a stable and well-formulated one. This realm of research has not been explored empirically in much detail in the literature. The goal of this paper is to understand and give an answer to a question concerning pricing accuracy using the parameters resulting from a correctly posed calibration problem in comparison with those inferred from a relaxed calibration. Our empirical findings indicate that regularized calibration is only to be recommended when considering out-of-sample pricing for a long time horizon.

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