The Value of Multivariate Model Sophistication: An Application to Pricing Dow Jones Industrial Average Options

41 Pages Posted: 21 Apr 2012

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

Francesco Violante

Maastricht University - Department of Economics

Date Written: February 20, 2012

Abstract

We assess the predictive accuracy of a large number of multivariate volatility models in terms of pricing options on the Dow Jones Industrial Average. We measure the value of model sophistication in terms of dollar losses by considering a set 248 multivariate models that differ in their specification of the conditional variance, conditional correlation, and innovation distribution. All models belong to the dynamic conditional correlation class which is particularly suited because it allows to consistently estimate the risk neutral dynamics with a manageable computational effort in relatively large scale problems. It turns out that the most important gain in pricing accuracy comes from increasing the sophistication in the marginal variance processes (i.e. nonlinearity, asymmetry and component structure). Enriching the model with more complex correlation models, and relaxing a Gaussian innovation for a Laplace innovation assumption improves the pricing in a smaller way. Apart from investigating directly the value of model sophistication in terms of dollar losses, we also use the model confidence set approach to statistically infer the set of models that delivers the best pricing performance.

Keywords: option pricing, economic loss, forecasting, multivariate GARCH, model confidence set

JEL Classification: C10, C32, C51 C52, C53, G10

Suggested Citation

Rombouts, Jeroen and Stentoft, Lars and Violante, Francesco, The Value of Multivariate Model Sophistication: An Application to Pricing Dow Jones Industrial Average Options (February 20, 2012). CIRANO - Scientific Publications 2012s-05. Available at SSRN: https://ssrn.com/abstract=2043101 or http://dx.doi.org/10.2139/ssrn.2043101

Jeroen Rombouts (Contact Author)

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

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

Francesco Violante

Maastricht University - Department of Economics ( email )

P.O. Box 616
Maastricht, 6200 MD
Netherlands

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