Computational Statistics & Data Analysis 52 (2008) 2877 – 2891

www.elsevier.com/locate/csda

Sequential calibration of options

Erik Lindström, Jonas Ströjby, Mats Brodén, Magnus Wiktorsson∗ , Jan Holst
Division of Mathematical Statistic, Centre for Mathematical Sciences, Lund University, Box 118, SE-22100 Lund, Sweden

Available online 29 August 2007

Abstract
Robust calibration of option valuation models to quoted option prices is non-trivial but crucial for good performance. A framework
based on the state-space formulation of the option valuation model is introduced. Non-linear (Kalman) filters are needed to do
inference since the models have latent variables (e.g. volatility). The statistical framework is made adaptive by introducing stochastic
dynamics for the parameters. This allows the parameters to change over time, while treating the measurement noise in a statistically
consistent way and using all data efficiently. The performance and computational efficiency of standard and iterated extended Kalman
filters (EKF and IEKF) are investigated. These methods are compared to common calibration such as weighted least squares (WLS)
and penalized weighted least squares (PWLS). A simulation study, using the Bates model, shows that the adaptive framework is
capable of tracking time varying parameters and latent processes such as stochastic volatility processes. It is found that the filter
estimates are the most accurate, followed by the PWLS estimates. The estimates from all of the advanced methods are significantly
closer to the true parameters than the WLS estimates which overfits data. The filters are also faster than least squares methods. All
calibration methods are also applied to daily European option data on the S&P 500 index, where the Heston, Bates and NIG-CIR
models are considered. The results are similar to the simulation study and it can be seen that the overfitting is a real problem for the
WLS estimator when applied complex models.
© 2007 Elsevier B.V. All rights reserved.

Keywords: Non-linear Kalman filters; Calibration; Option valuation

1. Introduction

The predictive power of parametric option valuation models was recognized immediately after the Black and Scholes
(1973) model was introduced, cf. Campbell et al. (1997). More recent models have included jumps, see Merton (1976),
stochastic volatility, see e.g. Hull and White (1987) and Heston (1993) and state dependent diffusion terms, see e.g.
Dupire (1994) and Derman and Kani (1994) in order to improve the predictive power further. Today, models use a
combination of jumps, stochastic volatility and local volatility, see e.g. Bates (1996), Duffie et al. (2000), Carr et al.
(2003b), Chernov et al. (2004), and Carr and Wu (2004). The purpose of this paper is to outline a framework in which
these advanced models can be adaptively calibrated to data.
There are some issues when working with option data. A serious problem is the absence of a single quoted mar-
ket price. Instead, ask and bid prices are quoted and it is common practice to approximate the market price by the

∗ Corresponding author. Fax: +46 46 2224623.

E-mail address: [email protected] (M. Wiktorsson).

0167-9473/$ - see front matter © 2007 Elsevier B.V. All rights reserved.
doi:10.1016/j.csda.2007.08.009
2878 E. Lindström et al. / Computational Statistics & Data Analysis 52 (2008) 2877 – 2891

mid-price of these. Using the mid-price increases the risk for overfitting as any parameter vector yielding option
values within the bid–ask spread is acceptable with respect to the arbitrage conditions. The overfitting is accentu-
ated when using state of the art models as complex models are more prone to overfitting than simpler, transparent
models.
Another difficulty arises from the fact that market properties change over time. This can be e.g. macro-economic
events as well as investor preferences, corresponding to time varying P and Q measures, respectively. Time varying
parameters make adaptive calibration necessary. Less complex models are easier to adapt to changing conditions and
are therefore often used.
Models can be calibrated using data mining methods if the main purpose is to interpolate or predict prices of
contracts of the same type as the calibration instruments. However, good parameter estimates are needed if the pur-
pose of the calibration is applications like hedging, risk management or pricing exotics. The most common calibra-
tion technique is some version of daily least squares estimation, which provides good in sample predictions but is
also known to be notoriously non-robust to outliers giving bad parameter estimates, cf. Cont and Tankov (2004).
A problem frequently associated with the least squares calibration methods is multimodal loss functions, making
numerical optimization difficult. Several algorithms designed to reduce this problem by adding penalties have been
suggested. However, the main purpose of these is to improve the numerical stability, not the quality of the parameter
estimates.
Adaptive estimators are rare in the academic literature but commonly used in the industry, often using some ad hoc
adjustment. The dominating approach is to estimate the parameters using rolling non-linear regression techniques,
often in combination with some penalty.
This paper suggests that standard least squares methods should be replaced by a non-linear (Kalman) filter method,
as this decomposes the residual error into changes in the latent variables (e.g. volatility) and pricing errors. The Kalman
filter will automatically use all data but assign more weight to recent data in a statistically sound way.
The method is made adaptive by introducing the parameters as latent states, and assigning dynamics to these. Filtering
the augmented latent process will estimate the original latent state and parameters simultaneously. We find that the
proposed filter method is both faster than and at least as accurate as the least squares methods on the estimation and
validation set and significantly more accurate when pricing other contracts.

2. Option valuation

It is essential that the theoretical value of the calibration instruments (i.e. the options used in the calibration) can be
calculated with high accuracy using limited computational resources. These requirements rule out many quoted options,
essentially restricting the available instruments to European call and put options. The values of these instruments can
be obtained using Fourier methods, cf. Carr and Madan (1999).
The Fourier transform based techniques are both fast and fairly accurate. The main limitation is that we need to
know the characteristic function for the log stock price in closed form. However, for a fairly large class of stock price
models e.g. Black–Scholes (Black and Scholes, 1973), Merton (Merton, 1976), Heston (Heston, 1993), Bates (Bates,
1996), Normal inverse Gaussian (NIG) (see e.g. Barndorff-Nielsen, 1997 and the references therein ), variance Gamma
(VG) (Madan and Seneta, 1990), BNS (Barndorff-Nielsen and Shepard, 2001, 2002), CGMY (Carr et al., 2002),
finite moment log-stable (FMLS) (Carr and Wu, 2003), NIG-CIR model (Carr et al., 2003b), a class of time-changed
exponential Lévy models (Carr and Wu, 2004; Huang and Wu, 2004), etc. the characteristic function is available in
closed form. We will consider some of these models in detail below (cf. Section 2.1). The Fourier transform based
methods have been used in financial mathematics for some time now (see Carr and Madan, 1999) for a good refer-
ence to start with. A long list of references to articles using Fourier transform based methods can be found in Carr
et al. (2003a).

2.1. Stock price models

In this paper we consider the Bates model (Bates, 1996) and a sub-model (cf. below) as well as the NIG-CIR model
(cf. below). This choice of models is based on the results in Schoutens et al. (2004).
 E. Lindström et al. / Computational Statistics & Data Analysis 52 (2008) 2877 – 2891 2879

2.1.1. The Bates model and its sub-models

The dynamics for the Bates model under the risk-neutral measure Q is given by
(S)

dSt = rS t dt + Vt St dWt + St dJt , (1)
(V )

dVt = ( − Vt ) dt + V Vt dWt , (2)

where W (S) and W (V ) are standard Brownian motions with correlation ,  is the mean reversion rate,  is the mean
reversion level and with V0 as the initial value of V. Further, J is a compound Poisson process with intensity , having
jumps J such that log(1 + J ) ∈ N(, 2 ) and drift −(exp(2 /2 + ) − 1). This choice of drift for J forces the
discounted stock price process to be a martingale under Q. The Bates model contains several models (Black–Scholes,
Merton and Heston) as sub-models.

2.1.2. The NIG-CIR model

The NIG-CIR model is a Normal inverse Gaussian model that is stochastically time shifted by an integrated
Cox–Ingersoll–Ross stochastic volatility process. This model was first described in Carr et al. (2003b). Here the
stock price process

St = S0 exp(XIt ), (3)
t
where Xt is a NIG Lévy process, having parameters , , and where It = 0 Vs ds, Vt has dynamics according to
Eq. (2). Here the process {Vt }t  0 is assumed to be independent of the process {Xt }t  0 . It is, however, possible to
calculate the moment generating function without this assumption (see Huang and Wu, 2004; Carr and Wu, 2004).

2.2. Implementation and numerical aspects of the inverse Fourier transform

Lee (2004) treats error bounds for a fast Fourier transform (FFT) implementation of the Fourier transform method
and list the generalized Fourier transforms for some common pay-off functions such as e.g. the European call option.
Using FFT, one can obtain prices on a regularly spaced grid of log strike levels. Options observed on the market are
usually regularly spaced in the strike level, not the log strike level. If we are to evaluate the prices for a set of European
call options we need to fit the corresponding log strike levels into a regular spaced grid. The accuracy of FFT depends
on the grid spacing used, the interval on which integrand is evaluated and the properties of the characteristic function
of the log stock price. One FFT is needed for each time to maturity. This will lead to extra work if we have several
dates of maturity each with only a few strike levels. In order to avoid using different grids for different strike levels and
maturities we will here instead consider a Gauss–Laguerre quadrature implementation for the inverse Fourier transform.
In order to price a European call option we need to calculate the inverse Fourier transform (Lee, 2004):

1 ∞ e−ik − k est (1+ +i ) M

XT |t (1 + +i )

Ct (K, T − t) = p(t, T ) d , (4)
2 −∞ ( + i )(1 + + i )
where t is the present time, T time of maturity, K = exp(k) is the strike level, St = exp(st ) is the current dividend
corrected stock level (cf. Section 5 for precise details), MXT |t is the moment generating function of XT = log(ST /St )
under the risk neutral measure Q given St and p(t, T ) is a discounting factor for the time interval [t, T ]. This is well
defined if there exists a positive real number such that
1+
EQ [ST ] < ∞.

In order to price a Binary call option we instead need to calculate the inverse Fourier transform of (see Lee, 2004,
Eq. (5.1)):

1 ∞ e−ik − k est ( +i ) M
XT |t ( +i )

Bt (K, T − t) = p(t, T ) d . (5)
2 −∞ +i

The technical requirement is weaker; it is sufficient that EQ [ST ] < ∞.

2880 E. Lindström et al. / Computational Statistics & Data Analysis 52 (2008) 2877 – 2891

2.2.1. The Gauss–Laguerre method

The valuation formula is modified once more before describing the numerical integration method. Since any price
is a real number we have that
 ∞  −ik − k st (1+ +i ) 
1 e e MXT |t (1 + + i )
Ct (K, T − t) = p(t, T ) R d ,
2 −∞ ( + i )(1 + + i )
 
1 ∞ e−ik − k est (1+ +i ) MXT |t (1 + + i )

= p(t, T ) R d ,
0 ( + i )(1 + + i )

where the last equality comes from the fact that the real part of the integrand is an even function of . This integral can
now be approximated by a Gauss–Laguerre quadrature formula. In general we have that the Gauss–Laguerre quadrature
formula approximates an exponentially weighted integral from zero to infinity as
 ∞ n
(n) (n)

e−x f (x) dx ≈ wj f (xj )
0 j =1

(see e.g. Abramowitz and Stegun, 1972, p. 890). This paper use n = 100, which has turned out to be sufficient to get
reasonably accurate prices compared to the accuracy of the observed market prices. We do not claim that this holds true
in general, only for the models and options considered. Some care should be taken for short maturities and deep in the
money options. The weights and abscissas are pre-calculated and stored in order to increase the computational efficiency
of the algorithm. The complexity of the Gauss–Laguerre pricing algorithm will then be of the order n × noption , i.e. the
number of weights times the number of different options.

3. Calibration

Robust calibration of option valuation models to real world option prices is non-trivial but important for good
performance. Calibration is entangled with several difficulties, rendering many standard estimators suboptimal. This
section will review standard calibration methods, discuss some of the limitations of these and suggest a new framework
leading to better use of data.
A serious data problem is the absence of a single quoted market price. Instead, ask prices ctAsk (Ki , i ) and bid prices
Bid
ct (Ki , i ) are quoted. The market price is often approximated by the mid-price defined as

ctAsk (Ki , i ) + ctBid (Ki , i )

ct⋆ (Ki , i ) = (6)
2
and used when calibrating the option valuation models. This may not be an ideal approximation as any parameter
vector yielding option values inside the bid–ask spread is acceptable with respect to the arbitrage conditions. Using the
mid-price often leads to overfitting of data, and increases the risk for bad hedges.
Other problems can be attributed to parametric modelling. The vast majority of all option valuation models are
based on a parametric model for the underlying asset. The postulated stochastic process modelling the underlying asset
will only be an approximation of the real world price process, and will be unable to capture finer details of data. The
properties of the real price process will also change over time.
A common remedy is to use a simple model that is being recalibrated frequently. Simple models are less prone to
overfitting, and it can be argued that traders, knowing the limitations of simple models, can correct most of their pitfalls.
The latter claim is valid for transparent (simple) models, but not necessarily for advanced models.

3.1. Least squares methods

The dominating (textbook) calibration method, cf. Bates (1996), Hull (2002), Cont and Tankov (2004) and Schoutens
et al. (2004) is weighted least squares (WLS), i.e. taking the parameter (vector) that minimize the weighted sum of the
 E. Lindström et al. / Computational Statistics & Data Analysis 52 (2008) 2877 – 2891 2881

squared difference between the observed mid-price and the model predicted price

Ns
t 

LWLS
t () = s,i (cs⋆ (Ki , i ) − csModel (Ki , i ; ))2 , (7)
s=1 i=1
ˆt = arg min LWLS (). (8)
t
∈

It is statistically optimal (minimal variance of the estimates) to choose s,i as the inverse of the variance of the
residuals, although economic argument may suggest other weights. It is common to choose s,i = 0 ∀s < t to increase
the adaptiveness of the calibration, and to choose t,i as constant or proportional to the inverse of squared bid–ask
spread, thereby relating the size of the ask–bid spread to the quality of the quoted prices

1
t,i ∝ . (9)
(ctAsk (Ki , i ) − ctBid (Ki , i ))2

The WLS estimator using these weights has one strong limitation. An implicit assumption is made that old data do
not improve the estimation, as the summation is restricted to current data. The implication of this is quite dramatic,
as it implies that the past is of limited use to predict the current prices, and hence currently available information are
of limited use for predictions of the future! Another problem with this calibration setup is that it uses a small set of
observations, easily overfitting data. It is also known to be numerically difficult to find the parameters minimizing the
loss function. The latter is discussed in e.g. Cont and Tankov (2004), where a penalty function P (, 0 ) is added to the
loss function

LPWLS
t () = LWLS
t () + P (, 0 ). (10)

Here, 0 is a reference parameter vector and P (, 0 ) is a positive, locally convex function satisfying P (, 0 ) 0 and
P (0 , 0 )=0. Assuming that P (, 0 ) is globally convex and that LWLS
t () is well defined will, for a sufficiently large 
make LPWLS
t () globally convex, thus improving the performance of most numerical optimization schemes. However,
questions regarding exclusion of data remain unanswered. The penalty may also influence the loss function too much,
leading to biased parameters.
Several penalties have been used in the literature. Relative entropy is discussed in Cont and Tankov (2004). Another
approach related ridge regression or Tikhonov regularization (see e.g. Draper and Smith, 1998, Chapter 17) is a quadratic
penalty. We use the latter, using the deviation from the previously estimated parameters (0 = t−1 ) as penalty. Hence,
we get

P (, t−1 ) = ( − t−1 )2 . (11)

This penalty decrease the overfitting as the paths of the estimated parameters are smoothed over time, while simultane-
ously being easy to implement. It is also computationally advantageous, as many numerical optimization routines are
exact for quadratic problems. We have used Matlabs routine for non-linear least squares minimization, lsqnonlin,
to obtain the parameters and latent state.
The penalty parameter  can be chosen using different strategies. The literature on ridge regression suggests that the
parameter is chosen using the connections to Bayesian statistics, cross validation, Morozov discrepancy principle or
L-curve methods. We use the discrepancy principle discussed in Cont and Tankov (2004), choosing  as

Nt


ˆ = sup  : t,i (ct⋆ (Ki , i ) − ctModel (Ki , i ; ()))2 d0 d1 , (12)
i=1
Nt

d0 = t,i (ct⋆ (Ki , i ) − ctModel (Ki , i ; WLS
t ))2 , (13)
i=1

where d1 is chosen as d1 = 1.5. This improves the stability of the optimization, cf. Cont and Tankov (2004).
2882 E. Lindström et al. / Computational Statistics & Data Analysis 52 (2008) 2877 – 2891

3.2. Partially observed models

The least squares methods presented above do not explicitly model the time variation of the parameters, and fails to
separate the effects from the measurement errors and the time varying parameters consistently. Furthermore, the least
squares estimators do not use the structure of the latent processes when estimating the current value. This is hardly
optimal use of data.
Using the state-space formulation of the model, and interpreting the market price ambiguity generated by the ask–bid
spread as measurement errors addresses some of the problem mentioned. The model is then given as

ct⋆ (Ki , i ) = ctModel (Ki , i ; , Vt ) + t , (14)

Vt ∼ p(Vt |Vt−1 ; ), (15)

where t is a zero mean random vector having covariance matrix R = diag(t,i )/16, t,i is defined as in Section 3.1, 
is a constant parameter vector and Vt is the latent factor (volatility) propagated using the exact transition kernel. Filter
algorithms use all observations (not only the most recent observation) to estimate the latent process, and will weight
them optimally. This setup can be found in e.g. Bakshi et al. (2007), where an unscented Kalman filter was used to
estimate the latent volatility and the parameters were estimated offline using the quasi-maximum likelihood estimator.
The parameters can also be estimated by augmenting the latent state Vt with the parameter vector , thereby estimating
the parameters online using non-linear filtering. This is computationally easier than maximizing the quasi-likelihood.
The online calibration model is given as

ct⋆ (Ki , i ) = ctModel (Ki , i ; t , Vt ) + t , (16)

t = t−1 , (17)
Vt ∼ p(Vt |Vt−1 ; t−1 ). (18)

This is a dynamic Bayesian method, but does not address the problem of time varying parameters. Adaptive estimation
is achieved if the state-space model is reformulated as a self-organizing state-space model, augmenting the latent state
vector Vt with (a transformed version of) the parameter vector ˜ t = (t ), where the transformed parameter vector
is modelled as a random walk, cf. Anderson and Moore (1979) and Kitigawa (1998). This defines the self-organizing
state-space model as

ct⋆ (Ki , i ) = ctModel (Ki , i ; ˜ t , Vt ) + t , (19)

˜ t = ˜ t−1 +  ,
t (20)
Vt ∼ p(Vt |Vt−1 ; ˜ t−1 ). (21)

Adaptively estimating the parameters and the latent volatility is thus transformed into filtering of latent processes,
a problem for which statistical methods have been developed during the last decades, Anderson and Moore (1979),
Doucet (2001) and Künsch (2001).

3.2.1. Non-linear filtering

Finding the distribution of a latent, vector valued Markov process from noisy measurements is called the filtering
problem. Let {y1:n } be a shorthand notation for the observations y1 , . . . , yn and let {xn } be the value of the latent
process at time n. Furthermore, assume the measurement density p(yn |xn ), the state transition density p(xn+1 |xn ) and
initial state p(x0 ) to be known. These components can then be combined through Bayes’ formula giving filter density
p(xn |y1:n ). An attractive feature is that the filter density can be computed recursively, although the resulting filter
equations can rarely be solved in closed form. Two exceptions that can be solved are the finite state filter (the hidden
Markov model filter) and the Kalman filter, which solves the filter equations for linear, Gaussian systems, see Kalman
(1960) and Kalman and Bucy (1961).
The extended Kalman filter (EKF), see Anderson and Moore (1979) and Maybeck (1982), solve the non-linear
filtering problem by approximating the transition kernels by Gaussian distributions, leading to explicit filter equations.
The EKF is obtained by local linearization of the state transition process and the measurement equation. Assume that
 E. Lindström et al. / Computational Statistics & Data Analysis 52 (2008) 2877 – 2891 2883

the system of interest can be written as

yt = h(ut , xt ) + εt , (22)
xt = f (xt−1 , t ), (23)
where ε ∼ N(0, R),  ∼ N(0, Q) and ut is the set of Ft measurable variables (e.g. St , Ki , i , . . .). The EKF is then
given by
Extended Kalman Filter
Initialization: Let p(x0 ) ∼ N(m0 , P0 ).
Propagate: Propagate mean and covariance as
mt+1|t = f (mt , 0), (24)
Pt+1|t = F (mt , 0)Pt|t F T (mt , 0) + G(mt , 0)QGT (mt , 0). (25)

Updating: The mean and covariance of the filter density are given by

K = Pt+1|t H T (mt+1|t )(H (mt+1|t )Pt+1|t H T (mt+1|t ) + R)−1 , (26)

mt+1|t+1 = mt+1|t + K(yt+1 − h(ut+1 , mt+1|t )), (27)
Pt+1|t+1 = Pt+1|t − KH T (mt+1|t )Pt+1|t , (28)

and repeat the propagation and updating steps until t = T ,

where
jf jf jh
F (m, ) = (m, ), G(m, ) = (m, ), H (m) = (ut+1 , m). (29)
jx j jx
The linearization requires the system to be fairly linear to be accurate, and the filter may diverge if the system is too
non-linear.
A simple improvement of the EKF is the iterated EKF (IEKF), see Maybeck (1982), in which the update recursion
is replaced by iterating the following recursions a fixed number of iterations or until convergence.
Iterated Extended Kalman Filter
Updating (modified): Iterate until convergence

Ki+1 = Pt+1|t H T (zi )(H (zi )Pt+1|t H T (zi ) + R)−1 , (30)

zi+1 = mt+1|t + Ki+1 (yt+1 − h(ut+1 , zi ) − H T (zi )(mt+1|t − zi )), (31)
Pt+1|t+1 = Pt+1|t − Ki+1 H T (zi+1 )Pt+1|t , (32)

starting the recursion using z0 = mt+1|t .

The IEKF changes the point of linearization from mt+1|t to z, producing more accurate approximations of the filter
distribution when the measurements are informative, see Lefebvre et al. (2004). In fact, the linearization errors in the
IEKF update are smaller than the linearization errors in EKF and unscented Kalman filter updates. This makes the
IEKF our filter of choice as the latent dynamics in all models in this paper are linear.
Other non-linear filters can also be used, e.g. Lindström et al. (2006) implements both a standard bootstrap filter
and a hybrid bootstrap filter but does not find any support that these are competitive when using a modest number of
particles compared to the IEKF. This indicates that the measurement equation is sufficiently linear for the data used in
this paper.

3.2.2. Implementation
The filter algorithm cannot be applied to data without specifying an initial distribution of the latent states. We have
initialized the filter using the asymptotics given by the WLS estimator, i.e. taking m0 = WLS1 and P0 = Cov(WLS 1 ).
This is a reasonable prior and ensures that the filter has good starting values, and is not worse off than the WLS when
comparing the calibration methods.
Many parameters and latent states are restrained to compact or semi-infinite spaces. These have been transformed
onto the real line, as the filters are based on Gaussian approximations. We denote the transformed parameters by , ˜
2884 E. Lindström et al. / Computational Statistics & Data Analysis 52 (2008) 2877 – 2891

cf. Eqs. (19)–(21). Neglecting to transform the parameters may cause the algorithm to break down. Standard, bijective
transformations have been used, e.g. taking the logarithm of variables with support on the positive real line and applying
the inverse hyperbolic tangent (arctanh) to variables with support on [−1, 1]. The transition kernel for latent volatility
is approximated by a Gaussian distribution, using the exact conditional moments. The implemented model is given by

ct⋆ (Ki , i ) = ctModel (Ki , i ; ˜ t , Vt ) + t , (33)

˜t = ˜ t−1 + t , (34)
P P
Vt = P (1 − e−  ) + e−  Vt− + Pt Vt ,

(35)
2V P 2V (Vt− P
− ) P 2V (P − 2Vt− ) −2P 
Pt = + e−  + e . (36)
2P P 2P
The latent volatility evolves according to the P-dynamics, while our parameters are Q-parameters. These are related
through risk premiums V according to

P
 = P (1 + V ), = . (37)
1 + V
Several studies estimating the risk premiums have found that their estimates are either weakly significant or even
insignificant, cf. Polson and Stroud (2003) on S&P 500 data and Carr and Wu (2007) on currency option data. We have
been unable to get statistically significant estimates on our (shorter) set of data, and have therefore approximated the
P-dynamics with the Q-dynamics (V = 0), although simultaneous estimation of Q-parameters and risk premiums is
preferred when possible.
What remains is to specify the covariance matrix of  . We have for computational and statistical simplicity assumed
that increments of each parameter are pair wise independent. It is well known that stochastic volatility is clearly needed
to fit data, while the gain from introducing jumps is smaller (but still significant). We have therefore chosen to allow for
different covariances, assigning covariance Qc to parameters related to the continuous (stochastic volatility) component
and covariance QJ to parameters related to the jump component. These are different, while covariances in each group
are identical. The size of the covariances has been estimated using quasi-maximum likelihood on an independent set
of data, simulated using parameters that resemble those we are interested in estimating.

4. Simulation study

The methods are first tested in a simulation study. Data have been simulated from the Bates model, cf. Section 2.1,
as this model includes jumps and stochastic volatility. The initial Q-parameters were chosen according to Bakshi et al.
(1997) to mimic S&P 500 index as closely as possible, see Table 1.
The Bates model has seven parameters and one latent state which are grouped together in the augmented latent state
vector, x = (, , V , , Vt , , , ). Prices have been generated with constant parameters except Vt which follows a
stochastic process according to (2), and  and  which have been varied as depicted in Fig. 1. The purpose of this setup
is to test whether the methods can track changing parameters.
The index level and latent volatility were simulated under the P-dynamics, where we used V =−0.25, while the jump
parameters were identical under P and Q. Using different volatility parameters under P and Q, while filtering using
only Q-parameters will emulate real data, and test our approximation (cf. Section 3.2) under controlled conditions.
The total length of the data set is 200 trading days. Hundred European call options over a range of 20 strikes with
moneyness between 0.65 and 1.35 and five maturities were generated each trading day. Our options data have bid–ask

Table 1
Parameters for the Bates model used in the simulation study

Parameter S0   V  V0   

Value 1000 2.03 0.04 0.38 −0.7 0.0576 0.59 −0.05 0.07
 E. Lindström et al. / Computational Statistics & Data Analysis 52 (2008) 2877 – 2891 2885

κ ξ σV ρ
3.5 0.06 0.5 −0.3

3 0.055 −0.4
0.45
0.05 −0.5
2.5
0.045 0.4
−0.6
2
0.04 0.35 −0.7
1.5
0.035 −0.8
1 0.3
0.03 −0.9

0.5 0.025 0.25 −1

50 100 150 200 50 100 150 200 50 100 150 200 50 100 150 200

Vt λ µ δ
0.09 2 0.6 0.2
0.08 1.8 0.4 0.18
0.07 1.6 0.16
1.4 0.2 0.14
0.06
0.05 1.2 0 0.12
1 0.1
0.04 −0.2
0.8 0.08
0.03
0.6 −0.4 0.06
0.02 0.4 0.04
0.01 −0.6
0.2 0.02
0 0 −0.8 0
50 100 150 200 50 100 150 200 50 100 150 200 50 100 150 200

Fig. 1. Bates simulated data. True parameters (solid lines), WLS estimates (circles) and IEKF estimates (dots).  and  are changing over time.

spread of approximately $1, so we have added noise to the option prices, cf. Eq. (19), to mimic the mid-price uncertainty
present in the real world option prices. The noise is Gaussian with a standard deviation of one-fourth of the spread,
1
cf. R = cov() = 16 . The motivation behind this choice is that we expect at least 95% of the true option prices to be
within the spreads. Interpreting the error as a pure truncation error would give a slightly different R. The set of option
prices was split into an estimation set of 40 options per day and a validation set of 60 options per day. The options in
the different sets were selected at random each day.
Calibration can be seen as a mapping between, in our case, European calls and a set of latent processes. If the
validation is performed using the same mapping, e.g. by pricing out-of-sample calls, the interpolation capacity of the
calibrated pricing model is tested. If on the other hand the quality of the calibrated model is to be tested, a different
mapping is more suitable. A convenient choice in this simulation study is the European binary option, which can be
priced in the same framework as the European call as seen in Section 2.2. Prices of binary options are thus calculated
both for the true parameters and for the filtered states and compared using RMSE.
The time consumption has been measured by the average time consumption per step, i.e. the average time consumption
of daily recalibration. Since the time consumption is dependent of factors not specific to the actual estimation method,
e.g. the performance of the computer used, we are more interested in the ordering among the methods than the actual
numbers.
The parameters have been estimated using two different filters: EKF and IEKF. The state noise covariance matrix Q
was determined using quasi-maximum likelihood estimation as discussed in Section 3.2. We found that Qc = 5 × 10−3
and QJ = 10−4 to be optimal.
As a benchmark the parameters have also been estimated using standard and penalized WLS (PWLS), cf.
Section 3.1. The least squares estimators were initialized with the true parameter values. The PWLS used d1 = 1.5,
giving ˆ ≈ 10. We have used ˆ = 10 throughout the simulation study.

4.1. Results

The IEKF and WLS estimated parameters are depicted in Fig. 1 in addition to the true parameter values. It can be
seen that the IEKF estimates are closer to the true parameter values than the WLS estimates. We have not plotted the
2886 E. Lindström et al. / Computational Statistics & Data Analysis 52 (2008) 2877 – 2891

Table 2
Summary statistics for the simulated Bates model

Filter Set IS (%) RMSE calls RMSE parameters RMSE binary (10−5 ) Average time (s)

EKF Est. 91.50 0.0924 0.0017 0.0572 0.5933

Val. 88.63 0.1078 – – –
IEKF Est. 96.86 0.0546 0.0018 0.0354 2.8916
Val. 93.65 0.0712 – – –
PWLS Est. 96.98 0.0536 0.0066 0.0556 6.4099
Val. 93.33 0.0732 – – –
WLS Est. 97.04 0.0521 2.8305 0.1452 135.67
Val. 92.43 0.0783 – – –

The RMSE for parameters are over all eight parameters. Bold face indicates the best method for that measure.

EKF and PWLS, these being intermediary in performance. WLS estimates far from the true values were moved to the
edge the subplots. This problem was mostly present in the estimates of the jump intensity  and jump volatility  as can
be seen in the figure. The IEKF (and EKF, PWLS) estimates are more stable over time compared to the WLS estimates,
and all the methods, possibly except WLS, estimate the latent process Vt very well. Even better, all methods are capable
of tracking time varying parameters with reasonable accuracy. This holds both for slowly varying parameters  and 
and for discontinuities in the  parameter.
Table 2 displays the numerical results of the measured fit for the different estimators. As expected (defined) the WLS
have the best fit in sample. On the validation set the IEKF and the PWLS perform the best. The PWLS drops more in
performance on the validation set, indicating a slight overfitting, but still much better than the WLS. When measuring
the RMSE of the call prices for the different methods we again see the WLS performing best in sample and the IEKF
out of sample.
In terms of parameter RMSE, the filter methods clearly outperform the least squares methods, the WLS being several
orders of magnitude larger. This result is consistent with the overfitting we saw on the European call options and the
graphical results in Fig. 1. When considering European binary options, we again see a clear advantage for the IEKF,
while the EKF and PWLS being approximately equal. The RMSE for the WLS is much larger than for any of the other
methods.
In terms of speed, the EKF is the clear winner. It is our subjective belief from simulations using the Heston model and
Bates model that the WLS estimator suffers from the curse of dimensionality more than the filter methods. The larger
parameter space requires more function evaluation for the minimization routine, yielding increased computational time
or decreased precision. The estimation set in our simulation is quite large, and it is not unexpected that the interpolation
capacity is sufficiently tuned on the estimation set to also perform well on the validation set for the WLS. If the number
of options per day were smaller or varied, the WLS would be more prone to overfitting.
It can be observed that the filter does not seem to suffer badly (compared to the WLS and PWLS) from using only
Q-parameters instead of using Q- and P-parameters simultaneously. We are therefore using the same approximation
(V = 0) on real data.

5. Empirical study

We have used daily data on S&P 500 index options, from November 5th, 2001 to May 5th, 2003, thus excluding data
containing a short term effect following September 11th. The original data set consisted of 38 225 quotes (date, strike,
ask price, bid price, index level, time to maturity and risk free interest rate). The raw data were processed according to
the following rules:

1. All options having time to maturity less than 6 trading days were excluded. These options are illiquid and highly
sensitive to changes in any variable.
2. Options having bid–ask spread larger than 5 have been excluded, in order to eliminate illiquid options. Also op-
tions having zero or negative 0 bid–ask spread have been eliminated as these are an effect of non-synchronous
trading.
 E. Lindström et al. / Computational Statistics & Data Analysis 52 (2008) 2877 – 2891 2887

3. The least liquid option when call and put options having identical strike and time to maturity is available has been
eliminated. It is well known that in-the-money options are traded infrequently compared to at-the-money or out-
of-the-money options. We have therefore excluded in-the-money options when at-the-money or out-of-the-money
options are available.

A total of 24 930 unique quotes remain after the processing. It is convenient to transform all quoted put options into
call options, using the put–call parity.
In practice r, the continuously compounded short rate (cf. Eq. (1)) is not constant and known. If we want to price
a claim at time t with maturity at time T, it is possible to replace r with the zero-coupon-bond (ZCB) yield over the
corresponding time period up to maturity (t, T ) and replace Q with the corresponding forward measure , FT instead.
A drawback with this approach is that we get different dynamics for the underlying stock for different maturities,
i.e. for each combination of t and T. This is of course due the fact that the ZCB yield varies with t and T. From a
valuation perspective this causes no serious problem, simply replacing r with the corresponding zero-coupon-yield and
set p(t, T ) equal to the ZCB price. The pricing formula Eq. (4) will look exactly the same.
Another adjustment is needed to account for dividends. It is common to approximate the dividend by a continuously
compounded dividend yield that depends on time and on time to maturity, hereafter denoted q(t, t + ). Ignoring
the dividend yield causes the transformed option prices to be discontinuous in the strike level. The dividend yield is
estimated such that the option prices are continuous in the strike level.
It is shown in e.g. Hull (2002) that dividends can be modelled by replacing the current value of the underlying equity
or index St by St e−q(t,t+) , when modelling a European call option maturing at t + . However, q(t, t + ) is not
quoted on the market, why we derive it from option quotes. It is well known from the put–call parity that
ct (Ki , ) − pt (Ki , ) = St e−q(t,t+) − Ki p(t, t + ). (38)
It is possible to estimate the corrected index level St e−q(t,t+) . Rearranging Eq. (38) and adding a noise term ei gives
St e−q(t,t+) = cKi , (t) − pKi , (t) + Ki p(t, t + ) + ei . (39)
The corrected index level can now be estimated by the sample mean, taken over overlapping mid-prices. The estimate
is stable over different Ki and reasonably stable over time.

5.1. Results

We have estimated three models on market data from options on the S&P 500 index, namely Heston, Bates and
NIG-CIR. Eighty percent of the processed data was used for estimation and the remainder for validation. The IEKF,
PWLS and WLS parameter estimates are presented in Figs. 2, 3 and 4. As in the simulation study, the axes are truncated
and some WLS estimates that obtained very large (absolute) values have been moved to the upper or lower edge of the
plots.
For the Heston model, being a sub-model of the Bates model, we used the state covariance found in the simulation
study. For the PWLS we set  as given by Eq. (12) to 10, also inherited from the simulation study. A posterior numerical
calculation proved this a sensible choice. The result from the Heston estimation is depicted in Fig. 2. The WLS and
IEKF estimates (and PWLS) agree on ,  and Vt . However, the WLS is less robust on  and V giving highly varying
estimates.
The Bates model was used in the simulation study on a set of data designed to be similar to the actual S&P 500 data.
We optimized with respect to Q and  in the simulation and used the same values for the market data set. Also,  was
checked posterior to have a reasonably correct value. The result from the Bates estimation is depicted in Fig. 3. For
the highly influential latent volatility process Vt , the WLS and IEKF agree, while on the other parameters, the WLS is
much more erratic, cf. the simulation study in Section 4. The PWLS and IEKF on the other hand, agree to a large extent.
It should be noted though that all parameters move a lot and are from being constant. For the jump intensity  the WLS
sometimes gave extreme estimates (this has been truncated in the figure), something it counteracts by lowering both
the expected value  and standard deviation . Also note the similarity with the Heston model of the volatility process
and its related parameters for the IEKF and PWLS. This, however, does not hold for the WLS.
The NIG-CIR model proved to be somewhat harder to find good parameter settings since we had no prior experience
from simulation study. We expect similar variation of the parameters in the NIG-CIR model as in the Bates model, and
2888 E. Lindström et al. / Computational Statistics & Data Analysis 52 (2008) 2877 – 2891

κ ξ σV
16 0.1 1.5
14 0.09
0.08
12
0.07 1
10 0.06
8 0.05
6 0.04
0.03 0.5
4
0.02
2 0.01
0 0 0
50 100 150 200 50 100 150 200 50 100 150 200

ρ Vt
−0.3 0.16
−0.35 0.14
−0.4
0.12
−0.45
−0.5 0.1
−0.55 0.08
−0.6 0.06
−0.65
0.04
−0.7
−0.75 0.02
−0.8 0
50 100 150 200 50 100 150 200

Fig. 2. Heston on market data. WLS (circles), PWLS (thin line) and IEKF estimates (thick line).

κ ξ σV ρ
12 0.1 1.8 −0.1

0.09 1.6 −0.2

10
0.08 1.4 −0.3
0.07
8 1.2 −0.4
0.06
1 −0.5
6 0.05
0.8 −0.6
0.04
4 0.6 −0.7
0.03

0.02 0.4 −0.8

2
0.01 0.2 −0.9

0 0 0 −1
2001−Dec 2002−May 2002−Oct 2003−Apr 2001−Dec 2002−May 2002−Oct 2003−Apr 2001−Dec 2002−May 2002−Oct 2003−Apr 2001−Dec 2002−May 2002−Oct 2003−Apr

Vt λ µ δ
0.14 3 0.15

0.12 0.05
2.5

0.1 0
2 0.1

0.08 −0.05
1.5
0.06 −0.1

1 0.05
0.04 −0.15

0.5
0.02 −0.2

0 0 −0.25 0
2001−Dec 2002−May 2002−Oct 2003−Apr 2001−Dec 2002−May 2002−Oct 2003−Apr 2001−Dec 2002−May 2002−Oct 2003−Apr 2001−Dec 2002−May 2002−Oct 2003−Apr

Fig. 3. Bates on market data. WLS (circles), PWLS (thin line) and IEKF estimates (thick line).
 E. Lindström et al. / Computational Statistics & Data Analysis 52 (2008) 2877 – 2891 2889

κ ξ σ Vt
16 0.4 5 1

4.5 0.9
14 0.35
4 0.8
12 0.3
3.5 0.7
10 0.25
3 0.6

8 0.2 2.5 0.5

2 0.4
6 0.15
1.5 0.3
4 0.1
1 0.2
2 0.05
0.5 0.1

0 0 0 0
2001−Dec 2002−May 2002−Oct 2003−Apr 2001−Dec 2002−May 2002−Oct 2003−Apr 2001−Dec 2002−May 2002−Oct 2003−Apr 2001−Dec 2002−May 2002−Oct 2003−Apr

δ α β α/β
14 80 0 0

−2
12 70
−5 −4
60
10 −6

50 −8
−10
8
40 −10
6
−15 −12
30
−14
4
20
−20 −16
2 10 −18

0 0 −25 −20
2001−Dec 2002−May 2002−Oct 2003−Apr 2001−Dec 2002−May 2002−Oct 2003−Apr 2001−Dec 2002−May 2002−Oct 2003−Apr 2001−Dec 2002−May 2002−Oct 2003−Apr

Fig. 4. NIG-CIR on market data. WLS (circles), PWLS (thin line) and IEKF estimates (thick line).

Table 3
The Heston, Bates and NIG-CIR models have been calibrated to a number of S&P 500 data sets using the different estimation methods

Filter Set Heston Bates NIG-CIR

IS (%) RMSE IS (%) RMSE IS (%) RMSE

EKF Est. 71.72 0.8080 76.68 0.6252 75.00 0.9331

Val. 70.27 0.7772 76.20 0.6335 74.13 0.9651
IEKF Est. 77.08 0.4609 85.99 0.3615 87.93 0.3242
Val. 76.08 0.4781 85.13 0.3615 86.93 0.3309
PWLS Est. 75.04 0.4796 83.35 0.3796 86.48 0.3450
Val. 74.25 0.4934 82.69 0.3830 85.49 0.3466
WLS Est. 77.75 0.4569 89.57 0.2914 87.59 0.3266
Val. 76.06 0.4760 82.69 0.3201 85.78 0.3393

The table contains the global fit error measurements for the calibrated model in sample (estimation set) and out of sample (validation set) for the
different estimation methods.

used the same settings. Other parameter values were also tested but no improvement was achieved. The result from
the NIG-CIR estimation is depicted in Fig. 4. Note that for the latter part of the data set, the WLS estimator has given
fairly unrealistic estimates, probably getting stuck in a local minimum. This is also seen in Table 3. Further, the ratio
/ , having a similar interpretation as the correlation in the Bates model, is fairly constant for the IEKF and PWLS,
but varies a lot for the WLS.
Global fit of the models has been measured in terms of inside spread (IS) and RMSE of the predicted prices in the
same way as in the simulation study. These results are presented in Table 3. No evaluation with respect to more exotic
contracts has been made.
2890 E. Lindström et al. / Computational Statistics & Data Analysis 52 (2008) 2877 – 2891

Since the validation set only consists of approximately 20% of the options, we expect the interpolation capacity
from the WLS estimates to be sufficiently tuned to also perform well out of sample, something that is confirmed in
Table 3. This is most evident in the simpler Heston model, while for the more complex models, evidence of overfitting
is seen. On the other hand we expect the IEKF to perform up to par with the WLS whilst still achieving stable parameter
estimates. This is confirmed by the parameter trajectories shown in Figs. 2–4 as well as the statistics in Table 3. As in
the simulation study, the IEKF performs best out of sample on all three models, indicating a well calibrated market
model and not just interpolation of the prices in the estimation set. It is worth noting that the WLS still overfits, as is
most evident in the Bates model where there is a substantial difference between in sample and out of sample IS.

6. Conclusions

The filter technique proposed in the paper has been evaluated on simulated and market option data. The filter estimates
have been compared to the standard WLS estimates as well as to estimates from a PWLS method. The overall impression
is that filter methods provide faster, more stable and more robust estimation than WLS.
When dealing with market quoted prices, the use of mid-price introduces a risk for overfitting. We find abundant
evidence of overfitting in the WLS estimates. The limitation of the standard WLS implementation is that it only uses
data from the current observation, whereas the filter methods make optimal use of past and current observations. An
intermediary approach to reduce overfitting is the PWLS, but this lacks the optimal weighting of past and current
information present in the filter.
We performed a simulation study on the Bates model to evaluate the different methods under controlled circumstances.
The WLS achieved a high in sample fit, with the PWLS and IEKF being close behind. The ordering changed out of
sample with the IEKF being better than the WLS. This indicates that the WLS overfitted to data. The IEKF on the other
hand managed to find the actual parameter values, and therefore excelling on the other metrics, especially when pricing
binary options. Even the EKF manages to track the parameters well but the inferior linearization means that it is not
capable of fine-tuning the more influential parameters such as the volatility to the extent that the IEKF does. Also, the
amount of time required by the different methods makes IEKF stand out even more.
A similar study was performed on S&P 500 option data. The pattern from the simulation study was repeated. The
filter methods managed to provide stable estimates across models while the WLS is more erratic and has a poorer
performance on the complex models. In fact we experienced some convergence issues for the WLS on the NIG-CIR
model. We can only speculate that the parameter estimates from the IEKF and PWLS represent the evolution some
actual market model, something that needs to be checked using a different mapping than European calls similar to the
binary calls in the simulation study.
These results provide evidence that the self-organizing state-space model, combined with an IEKF is a promising
method for option calibration. The IEKF is shown to be both faster and more accurate than standard methods when
applied to different market models. We believe that a similar behaviour can be expected from the filter for other models
and other data sets.

Acknowledgements

We would like to thank an anonymous referee and the guest editor for helpful comments and suggestions. Erik
Lindström gratefully acknowledges financial support from the Bank of Sweden Tercentenary Foundation under Grant
P2005-0712, Jonas Ströjby gratefully acknowledges financial support from the Swedish Research Council under Grant
2005-2799 and Magnus Wiktorsson gratefully acknowledges financial support from the Swedish Research Council
under Grant 2002-5415.

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