Citation

Discussion Paper Details

Please find the details for DP4960 in an easy to copy and paste format below:

Full Details   |   Bibliographic Reference

Full Details

Title: Loss Functions in Option Valuation: A Framework for Model Selection

Author(s): Dennis Bams, Thorsten Lehnert and Christian C Wolff

Publication Date: March 2005

Keyword(s): estimation risk, GARCH, implied volatility, loss functions and option pricing

Programme Area(s): Financial Economics

Abstract: In this paper, we investigate the importance of different loss functions when estimating and evaluating option pricing models. Our analysis shows that it is important to take into account parameter uncertainty, since this leads to uncertainty in the predicted option price. We illustrate the effect on the out-of-sample pricing errors in an application of the ad hoc Black-Scholes model to DAX index options. Our empirical results suggest that different loss functions lead to uncertainty about the pricing error itself. At the same time, it provides a first yardstick to evaluate the adequacy of the loss function. This is accomplished through a data-driven method to deliver not just a point estimate of the pricing error, but a confidence interval.

For full details and related downloads, please visit: https://cepr.org/active/publications/discussion_papers/dp.php?dpno=4960

Bibliographic Reference

Bams, D, Lehnert, T and Wolff, C. 2005. 'Loss Functions in Option Valuation: A Framework for Model Selection'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=4960