Calibration of Pricing Models

Calibration of pricing models is the process of adjusting the parameters of a mathematical model so that it produces market-consistent prices for standard, liquid instruments. For example, a model might be calibrated to match the observed market prices of vanilla calls and puts.

Once calibrated, the model can be used to price more complex, illiquid exotic options. In crypto, this is a continuous process because the market environment changes so rapidly.

If the model is not properly calibrated, it will produce inaccurate prices, leading to arbitrage opportunities or significant trading losses. This is a delicate balance, as over-calibrating can lead to models that are too complex and prone to overfitting, while under-calibrating can result in models that do not reflect the market reality.

It is a fundamental task for any quant desk aiming to trade derivatives profitably.