RE: Comparison of models

Posted by Perissin Francesco on Oct 18, 2002; 12:57am
URL: http://quantlib.414.s1.nabble.com/Comparison-of-models-tp2252p2253.html

Hi I'd like to add a word, too....

>My basic question essentially is: if we take simple vanilla derivatives,
does it pay to invest in models which are
>more advanced that BS or Binomial?


As already written by Rama CONT, the point is building a model that fits the
prices of vanilla derivatives. The prices of vanillas are "always" correct
since, they are given by the market. The model essentially is used for
pricing and hedging exotic instruments, and the hedge is done using
vanillas.
So the answer could be "no", theoretically all models should give the same
prices (and very similar greeks) for vanillas. But rember: if you trade
vanillas, are they still vanilla the day after? On equities this could be
true most of the times, but on interest rates they are a bit less vanilla,
since the expiration dates of vanillas have changed .... THey are still
vanillas, but on day 2 you are not able to close your risks by trading other
vanillas!!!

This is not complete yet, since one could argue that the model is also used
for finding inconsistencies between vanilla prices, and arbitraging them. In
practices, due to transaction costs and bid-ask spreads, this practice is
rather difficult to implement...

Hope this helped somehow...

Francesco
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