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.