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Which options should be used for calibration?

When calibrating a model to the market we usually know the underlying asset price and are interested in calibrating our model to the vols from the vanilla option market to be able to price exotic options. 

Market-quoted vanilla options are almost always OTM --> likely that ITM options had their value inferred from OTM options. 

Reason: OTM option's value is driven more by its optionality, rather than its intrinsic value. 

We would therefore use the OTM option for calibration. 

 

 

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