Despite many questions about local and stochastic volatility available on this forum, i still have a few doubts left. Essentially I am seeking validation whether I am interpreting things correctly.
Q1. A very basic question: Why are different volatility surfaces used?
My take (please correct if i am wrong):
Implied volatility surface generated using Black-Scholes model is not able to price exotic options (with barriers) correctly. So we need local volatility and stochastic volatility surfaces. The parameters are calibrated so that these volatility surfaces match the implied volatility surface generated from the Black-Scholes model. For calibration we use vanilla options. Once these local volatility and stochastic volatility surfaces match the implied volatility surface generated using the Black-Scholes model and are able to price vanilla options correctly, it is used for pricing exotic products.
Few follow-up questions:
Q2. Why local volatility and stochastic volatility models try to match the volatility surface generated by the Black-Scholes model? Once these local and stochastic volatility surfaces have been generated, we don't need the volatility surface generated by the Black-Scholes model, the new volatility surface can be used for pricing both vanilla as well as exotic options. Is it the correct inference?