Rethinking Valuation and Pricing Models: Lessons Learned from the Crisis and Future Challenges
By Christian Hoppe and Greg N. Gregoriou
()
About this ebook
- Highlights pre-crisis best classical practices, identifies post-crisis key issues, and examines emerging approaches to solving those issues
- Singles out key factors one must consider when valuing or calculating risks in the post-crisis environment
- Presents material in a homogenous, practical, clear, and not overly technical manner
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Rethinking Valuation and Pricing Models - Carsten Wehn
journals.
1
The Effectiveness of Option Pricing Models During Financial Crises
Camillo Lento∗ and Nikola Gradojevic∗∗
∗Lakehead University
∗∗Lakehead University and The Rimini Centre for Economic Analysis
Chapter Outline
1.1 Introduction
1.2 Methodology
1.3 Data
1.4 Results
1.5 Concluding Remarks
References
1.1 Introduction
Options can play an important role in an investment strategy. For example, options can be used to limit an investor’s downside risk or be employed as part of a hedging strategy. Accordingly, the pricing of options is important for the overall efficiency of capital markets.¹ The purpose of this chapter is to explore the effectiveness of the original Black and Scholes (1973) option pricing model (BS model) against a more complicated non-parametric neural network option pricing model with a hint (NN model). Specifically, this chapter compares the effectiveness of the BS model versus the NN model during periods of stable economic conditions and economic crisis conditions.
Past literature suggests that the standard assumptions of the BS model are rarely satisfied. For instance, the well-documented volatility smile
and volatility smirk
(Bakshi et al., 1997) pricing biases violate the BS model assumption of constant volatility. Additionally, stock returns have been shown to exhibit non-normality and jumps. Finally, biases also occur across option maturities, as options with less than three months to expiration tend to be overpriced by the Black–Scholes formula (Black, 1975).
In order to address the biases of the BS model, research efforts have focused on developing parametric and non-parametric models. With regard to parametric models, the research has mainly focused on three models: The stochastic volatility (SV), stochastic volatility random jump (SVJ) and stochastic interest rate (SI) parametric models. All three models have been shown to be superior to the BS model in out-of-sample pricing and hedging exercises (Bakshi et al., 1997). Specifically, the SV model has been shown to have first-order importance over the BS model (Gencay and Gibson, 2009). The SVJ model further enhances the SV model for pricing short-term options, while the SI model extends the SVJ model in regards to the pricing of long-term options (Gencay and Gibson, 2009).
Although parametric models appear to be a panacea with regard to relaxing the assumptions that underlie the BS model, while simultaneously improving pricing accuracy, these models exhibit some moneyness-related biases for short-term options. In addition, the pricing improvements produced by these parametric models are generally not robust (Gencay and Gibson, 2009; Gradojevic et al., 2009). Accordingly, research also explores non-parametric models as an alternative, (Wu, 2005). The non-parametric approaches to option pricing have been used by Hutchinson et al. (1994), Garcia and Gencay (2000), Gencay and Altay-Salih (2003), Gencay and Gibson (2009), and Gradojevic et al. (2009).
Non-parametric models, which lack the theoretical appeal of parametric models, are also known as data-driven approaches because they do not constrain the distribution of the underlying returns (Gradojevic et al., 2011). Non-parametric models are superior to parametric models at dealing with jumps, non-stationarity and negative skewness because they rely upon flexible function forms and adaptive learning capabilities (Agliardi and Agliardi, 2009; Yoshida, 2003). Generally, non-parametric models are based on a difficult tradeoff between rightness of fit and smoothness, which is controlled by the choice of parameters in the estimation procedure. This tradeoff may result in a lack of stability, impeding the out-of-sample performance of the model. Regardless, non-parametric models have been shown to be more effective than parametric models at relaxing BS model assumptions (Gencay and Gibson, 2009; Gradojevic and Kukolj, 2011; Gradojevic et al., 2009). Accordingly, the BS model is compared against a non-parametric option pricing model in this