Finance vs Physics (page 476) The models of physics describe physicalprocesses and are highly accurate. Theirparameters do not change through time.The models of finance describe humanbehavior. They are at best approximations.Parameters do change through time6RiskManagementandFinancialInstitutions3e,Chapter22,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 22, Copyright © John C. Hull 2012 Finance vs Physics (page 476) ⚫ The models of physics describe physical processes and are highly accurate. Their parameters do not change through time. ⚫ The models of finance describe human behavior. They are at best approximations. Parameters do change through time 6
CalibrationModels of finance are calibrated to marketprices daily As a result parameters change from day today For a particular option maturing in threemonths volatility might be 20% on Day 122% on Day 2, and 19% on Day 3.7RiskManagementandFinancialInstitutions3e,Chapter22,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 22, Copyright © John C. Hull 2012 Calibration ⚫ Models of finance are calibrated to market prices daily ⚫ As a result parameters change from day to day ⚫ For a particular option maturing in three months volatility might be 20% on Day 1, 22% on Day 2, and 19% on Day 3. 7
TheWayModelsAreUsuallyUsedin FinanceObservemodel pricesforsimilarinstrumentsthattradeImplymodelparametersInterpolateas appropriateValuenewinstrumentRiskManagementandFinancialInstitutions3e,Chapter22,CopyrightJohnC.Hull20128
The Way Models Are Usually Used in Finance Risk Management and Financial Institutions 3e, Chapter 22, Copyright © John C. Hull 2012 8 Observe model prices for similar instruments that trade Imply model parameters. Interpolate as appropriate Value new instrument