Calibration of Jump-Diffusion Option Pricing Models: A Robust Non-Parametric Approach

Rapport Interne CMAP Working Paper No. 490

39 Pages Posted: 22 Nov 2002

Date Written: September 2002

Abstract

We present a non-parametric method for calibrating jump-diffusion models to a finite set of observed option prices. We show that the usual formulations of the inverse problem via nonlinear least squares are ill-posed and propose a regularization method based on relative entropy. We reformulate our calibration problem into a problem of finding a risk neutral jump-diffusion model that reproduces the observed option prices and has the smallest possible relative entropy with respect to a chosen prior model. Our approach allows to conciliate the idea of calibration by relative entropy minimization with the notion of risk neutral valuation in a continuous time model. We discuss the numerical implementation of our method using a gradient based optimization algorithm and show via simulation tests on various examples that the entropy penalty resolves the numerical instability of the calibration problem. Finally, we apply our method to datasets of index options and discuss the empirical results obtained.

Keywords: levy process, jump-diffusion models, implied volatility, option pricing, model calibration, non-parametric methods, inverse problems, relative entropy, regularization

JEL Classification: G130, C63, C14

Suggested Citation

Cont, Rama and Tankov, Peter, Calibration of Jump-Diffusion Option Pricing Models: A Robust Non-Parametric Approach (September 2002). Rapport Interne CMAP Working Paper No. 490. Available at SSRN: https://ssrn.com/abstract=332400 or http://dx.doi.org/10.2139/ssrn.332400

Rama Cont (Contact Author)

University of Oxford ( email )

Mathematical Institute
Oxford, OX2 6GG
United Kingdom

HOME PAGE: http://https://www.maths.ox.ac.uk/people/rama.cont

Peter Tankov

ENSAE Paris ( email )

92245 Malakoff Cedex
France
91400 (Fax)

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