I had a conversation about this last night and thought it was worth writing some of it down and extending it a little. So…
Let’s begin with the market. For our purposes there are some known current market variables which we assume are correct. This could be a stock price, interest rates, a dividend yield — and perhaps one or more implied volatilities.
Secondly we have a model. The model is often, but not always, standard, i.e. shared between most market participants. Let’s start with standard models. Here the model is first calibrated to the known market variables.
At this point we are ready to use the model. There is a safe form of use and a less safe one. In the safe one we use the model as an interpolator. For instance we know the coupons of the current 2, 3, 5, 7 and 10 year par swaps (plus the interest rate futures prices and deposits) and we want to find the fair value coupon for a 4.3 year swap. Or we know the prices of 1000, 1050 and 1100 strike index options and we want to price a 1040 strike OTC of the same maturity.
The less safe use is when we use the model as an extrapolator. We want a 12 year swap rate, for instance, or the price of a 1200 strike option. That’s not too bad provided we don’t go too far beyond the available market data, but it is definitely a leap.
(Both of these, by the way, count as FAS 157 level 2.)
Note that there are two ways that we realise P/L in derivatives. Either we trade them or we hedge them. If we are in the flow business then trading is important. We need to use the same model as everyone else simply because we are in the oranges business and we need to kInow what everyone else thinks an orange is worth. We take a spread just like traders of other assets, buying for a dollar and selling for a dollar ten, or whatever. The book might well be hedged while we are waiting to trade, but basically we are in the moving business. Swaps books, index options, short term single stock, FX, interest rate and commodity options, and much plain vanilla options trading falls into this camp.
In the hedging business in contrast we trade things that we do not expect to have flow in. Most exotic option businesses are an example here, as are many long dated OTC options. There is no active market here so instead we have to hedge the product to maturity. Thus here the model hedge ratios are just as important as the model prices. Valuation should reflect the P/L we can capture by hedging using the model greeks over the life of the trade. Thus standard models are more questionable in the hedging business than in the moving business since it is not just their prices — which are correct by construction — but also their greeks that matter.
Things start to get really hairy when we move away from standard models. Now we are almost certainly dealing with products where there is no active market (some kinds of FX exotics are a counterexample) and we do not even know that the model prices are correct. There is genuine disagreement across the market as to what some of these things are worth. Different models also produce radically different hedge ratios. How can we judge the correctness of such a model? The answer is evident from the previous paragraph: it is correct if the valuation predicted can genuinely be captured by hedging using the model hedge ratios. [Note that this does not necessarily give a unique 'correct' model.]
In summary then: for flow businesses we need interpolators between known prices and, to a lesser extent, extrapolators. For storage businesses we need models which produce good hedge ratios.