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

The adage "all models are wrong, but some are useful" certainly applies to finance: Models that have been empirically invalidated remain in widespread use. Often, model usage contradicts the model assumptions: As market prices... [ view full abstract ]

The adage "all models are wrong, but some are useful" certainly applies to finance: Models that have been empirically invalidated remain in widespread use. Often, model usage contradicts the model assumptions: As market prices change, parameters in option pricing models, assumed to be time–invariant, are recalibrated. Incorrect models, and model misuse, represent an increasingly recognised source of risk - "model risk." We focus on two aspects of model risk: the inability of a model to fit market prices at a given point in time (calibration error) and the model risk due to recalibration of parameters (contradicting model assumptions).