Calibration
Setting a model's parameters so it reproduces the market prices of chosen instruments, such as fitting a rate tree so benchmark bonds price exactly. Other instruments are then priced consistently with them.
Where you will meet it
Calibration appears in 6 learning outcomes on the CFA syllabus. A few of them:
- Explain the idea of valuing a fixed-income instrument so that no arbitrage is possible
“Trading pressure removes such gaps, which is why models are calibrated to reproduce market prices.”
- Contrast valuing with the zero-coupon yield curve and valuing with an arbitrage-free binomial lattice
“For an option-free bond, pricing with the zero-coupon curve and pricing on a calibrated binomial lattice give the same value, because the lattice was built to reproduce that curve and fixed cash flows do not depend on which path rates take.”
- Explain how to apply the arbitrage-free approach when valuing a bond that contains embedded options
“To value a bond with embedded options, use a binomial tree calibrated to the benchmark curve with an assumed volatility, and value backward from maturity.”
- Explain the effect of interest rate volatility on what a callable or putable bond is worth
“The straight bond's value on a calibrated tree does not depend on volatility.”
Practise it
Practise calibration until it is automatic: questions that explain every wrong option.
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