Validating Exotic Option Models When Market Quotes Are Sparse

Summary

The document addresses how to assess an exotic option pricing model when direct market prices are scarce. It proposes first checking whether the contract can be reduced to a simpler exotic structure that has observable quotes; if so, the model should reproduce those quoted prices.

When no relevant quotes are available, the suggested approach is a historical hedging assessment. Simulate selling the exotic and hedging it according to the model across past market realizations, ideally spanning different regimes, then examine the resulting performance. Persistent losses may indicate that the model or its assumptions fail to represent market dynamics adequately for a seller. Persistent gains may instead suggest prices are too high to be competitive. This is a diagnostic rather than a definitive accuracy test: the document provides no calibration procedure, formal performance thresholds, or worked results, and the conclusions depend on the historical scenarios and hedge assumptions used.

Key ideas

• Match model values to observable quotes for simpler contracts into which the exotic can degenerate.
• When direct quotes are absent, assess a model through historical sell-and-hedge simulations.
• Include different market regimes when selecting historical realizations for the assessment.
• Repeated losses can signal unsuitable dynamics or hedging assumptions for a seller.
• Repeated gains can signal prices high enough to harm competitiveness, so neither outcome alone proves accuracy.

Tags

# Verify the accuracy of a model for exotic option if there is no enough data of market price every?


# Verify the accuracy of a model for exotic option if there is no enough data of market price every?












How to effectively verify the accuracy of a model(may be complicate) for exotic option, if there is no enough data of market price? Is there any related reference?

## Answer by Quantuple (score 2, accepted)

https://quant.stackexchange.com/a/36236

If your exotic contract specification can degenerate into a lighter exotic structure for which you can observe quotes, make sure you match them.

If you have nothing at all, try to assess how well you would have done, in average, by selling the exotic and hedging it according to your model assumptions for various past realisations of the market (ideally different regimes). If you always lost money in all scenarii, then your model - and the manner in which it captures the true market dynamics - is probably not suited for the sell-side. If you always made money, then your probably charging too high of a price and will not be competitive, hence not suited for the sell-side either.

As mentioned in the comments below, it may also help you to read the answers given to this related question.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.