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Module 3 Lesson 4

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28 views8 pages

Module 3 Lesson 4

Uploaded by

Shalabh Tewari
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Module 3: Lesson 4

BBC (1997) model calibration


Outline
▶ The art of calibration

▶ BCC (1997) calibration process

▶ Calibration results on EuroStoxx50 options

2
The art of calibration
Although we usually follow the same steps, the calibration process can take different forms:
▶ Which market variable are we calibrating to? Which error function?
- Mean Squared Error (MSE) of option market prices (call/put?):
N
1 X ∗ 2
min Cn − CnModel (α)
α N n=1

- MSE of relative option market price differences:


N  2
1 X Cn∗ − CnModel (α)
min
α N n=1 Cn∗

- MSE of options’ implied volatilities


N
1 X ∗ 2
min σ − σnModel (α)
α N n=1 n
3
BCC (1997) calibration steps
These are the SDEs for the BCC (1997) model:

√
dSt = (rt − rJ )St dt + νt St dZt1 + Jt St dNt
√
dνt = κν (θν − νt )dt + σν νt dZt2
√
drt = κr (θr − rt )dt + σr rt dZt3

So, much like with Bates (1996) calibration, we need to take a sequential path:

1. Calibration of short-rates model → CIR (1985) model calibration


2. With the short rates from step 1, global calibration of Stochastic Volatility → Heston (1993) model
3. Using the parameters from steps 2 and 1, locally calibrate the jump component → (adjusted) Merton
(1976) model
4. Using the parameters from steps 2 and 3 as guidance, globally calibrate the BCC (1997) model (using
short rates from step 1).
4
Calibration results BCC (1997)

5
Calibration results BCC (1997)

6
Calibration results BCC (1997)

7
Summary of Lesson 4
In Lesson 4, we have learned about:

▶ Main features of the calibration process


▶ Steps involved in the calibration of BCC (1997) model
▶ Results from BCC (1997) calibration to EuroStoxx50 options

⇒ References for this lesson:


Bakshi, Gurdip, et al. ”Empirical Performance of Alternative Option Pricing Models.” The Journal of Finance,
vol. 52, no. 5, 1997, pp. 2003–2049.

⇒ TO DO NEXT: In the notebook associated with this lesson, we will guide you through the complete
calibration process of the BCC (1997) model.

⇒ In the next module, we turn to Markov processes and chains, which are integral for the development of
reinforcement learning, a field that has been gaining importance in quantitative finance given its broad
applications.

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