Bayesian Option Pricing Using Mixed Normal Heteroskedasticity Models

51 Pages Posted: 12 Dec 2008 Last revised: 24 Feb 2009

See all articles by J. V. K. Rombouts

J. V. K. Rombouts

HEC Montreal; Catholic University of Louvain (UCL) - Center for Operations Research and Econometrics (CORE); Centre interuniversitaire sur le risque, les politiques économiques et l'emploi (CIRPÉE); Center for Interuniversity Research and Analysis on Organization (CIRANO)

Lars Stentoft

Department of Economics, University of Western Ontario; Center for Interuniversity Research and Analysis on Organization (CIRANO); Aarhus University - CREATES

Date Written: February 17, 2009

Abstract

While stochastic volatility models improve on the option pricing error when compared to the Black-Scholes-Merton model, mispricings remain. This paper uses mixed normal heteroskedasticity models to price options. Our model allows for significant negative skewness and time varying higher order moments of the risk neutral distribution. Parameter inference using Gibbs sampling is explained and we detail how to compute risk neutral predictive densities taking into account parameter uncertainty. When forecasting out-of-sample options on the S&P 500 index, substantial improvements are found compared to a benchmark model in terms of dollar losses and the ability to explain the smirk in implied volatilities.

Keywords: Bayesian inference, option pricing, finite mixture models, out-of-sample prediction, GARCH models

JEL Classification: C11, C15, C22, G13

Suggested Citation

Rombouts, Jeroen and Stentoft, Lars, Bayesian Option Pricing Using Mixed Normal Heteroskedasticity Models (February 17, 2009). Available at SSRN: https://ssrn.com/abstract=1315307 or http://dx.doi.org/10.2139/ssrn.1315307

Jeroen Rombouts

HEC Montreal ( email )

3000, Chemin de la Côte-Sainte-Catherine
Montreal, Quebec H3T 2A7
Canada

Catholic University of Louvain (UCL) - Center for Operations Research and Econometrics (CORE) ( email )

34 Voie du Roman Pays
B-1348 Louvain-la-Neuve, b-1348
Belgium

Centre interuniversitaire sur le risque, les politiques économiques et l'emploi (CIRPÉE) ( email )

Pavillon De Sève
Ste-Foy, Quebec G1K 7P4
Canada

Center for Interuniversity Research and Analysis on Organization (CIRANO) ( email )

2020 rue University, 25th floor
Montreal H3C 3J7, Quebec
Canada

Lars Stentoft (Contact Author)

Department of Economics, University of Western Ontario ( email )

London, Ontario N6A 5B8
Canada

Center for Interuniversity Research and Analysis on Organization (CIRANO)

2020 rue University, 25th floor
Montreal H3C 3J7, Quebec
Canada

Aarhus University - CREATES

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

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