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Detlefsen, Kai
Härdle, Wolfgang Karl
Year of Publication: 
Series/Report no.: 
SFB 649 discussion paper 2006,001
Option pricing models are calibrated to market data of plain vanillas by minimization of an error functional. From the economic viewpoint, there are several possibilities to measure the error between the market and the model. These different specifications of the error give rise to different sets of calibrated model parameters and the resulting prices of exotic options vary significantly. These price differences often exceed the usual profit margin of exotic options. We provide evidence for this calibration risk in a time series of DAX implied volatility surfaces from April 2003 to March 2004. We analyze in the Heston and in the Bates model factors influencing these price differences of exotic options and finally recommend an error functional. Moreover, we determine the model risk of these two stochastic volatility models for the time series and consider its relation to calibration risk.
calibration risk
model risk
Heston model
Bates model
barrier option
cliquet option
Document Type: 
Working Paper

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