Mathematical Finance Seminar
November 9, 2000 , 5:30 PM to 7:00 PM
John Hull, University of Toronto and Stern School of Business,
Wulin Suo, Queens University
A Test of the Implied Volatility Function Model As It Is Used By Traders to
Price And Hedge Exotic Options
The way researchers imagine derivatives models being used is often not the
same as the way traders actually use the models. Researchers usually assume
that a model's parameters will be chosen once and will remain unchanged
through time. In practice, traders usually recalibrate models daily, or even
more frequently, to market prices. In this paper, we test how well the
trader's approach works when the implied volatility function model of Dupire
(1994), Derman and Kani (1994), and Rubinstein (1994) is used for pricing and
hedging exotic options in stock index and foreign currency markets. We find
the model works well for compound options, but sometimes gives rise to large
pricing and hedging errors for barrier options.