pith. sign in

arxiv: 1406.2133 · v1 · pith:CM5MYO4Anew · submitted 2014-06-09 · 💱 q-fin.PR

Historical Backtesting of Local Volatility Model using AUD/USD Vanilla Options

classification 💱 q-fin.PR
keywords modelvolatilitylocaldeltahedgingdatahistoricalbacktesting
0
0 comments X
read the original abstract

The Local Volatility model is a well-known extension of the Black-Scholes constant volatility model whereby the volatility is dependent on both time and the underlying asset. This model can be calibrated to provide a perfect fit to a wide range of implied volatility surfaces. The model is easy to calibrate and still very popular in FX option trading. In this paper we address a question of validation of the Local Volatility model. Different stochastic models for the underlying can be calibrated to provide a good fit to the current market data but should be recalibrated every trading date. A good fit to the current market data does not imply that the model is appropriate and historical backtesting should be performed for validation purposes. We study delta hedging errors under the Local Volatility model using historical data from 2005 to 2011 for the AUD/USD implied volatility. We performed backtests for a range of option maturities and strikes using sticky delta and theoretically correct delta hedging. The results show that delta hedging errors under the standard Black-Scholes model are no worse than that of the Local Volatility model. Moreover, for the case of in and at the money options, the hedging error for the Back-Scholes model is significantly better.

This paper has not been read by Pith yet.

discussion (0)

Sign in with ORCID, Apple, or X to comment. Anyone can read and Pith papers without signing in.