Improving Non-Parametric Option Pricing during the Financial Crisis

Rimini Centre for Economic Analysis Working Paper No. 12-35

15 Pages Posted: 6 Aug 2012

See all articles by Dragan Kukolj

Dragan Kukolj

affiliation not provided to SSRN

Nikola Gradojevic

University of Guelph, Department of Economics and Finance; University of Bologna - Rimini Center for Economic Analysis (RCEA)

Camillo Lento

Lakehead University

Date Written: August 5, 2012

Abstract

Financial option prices have experienced excessive volatility in response to the recent economic and financial crisis. During the crisis periods, financial markets are, in general, subject to an abrupt regime shift which imposes a significant challenge to option pricing models. In this context, swiftly evolving markets and institutions require valuation models that are capable of recognizing and adapting to such changes. Both parametric and non-parametric pricing models have shown poor forecast ability for options traded in late 1987 and 2008. Surprisingly, the pricing inaccuracy was more pronounced for non-parametric models than for parametric models. To address this problem, we propose a novel hybrid methodology - modular neural network-fuzzy learning vector quantization (MNN-FLVQ) model - that uses the Kohonen unsupervised learning and fuzzy clustering algorithms to classify the S&P 500 stock market index options, and thereby detect a regime shift. In our empirical application, the results for the 2008 financial crisis demonstrate that the MNN-FLVQ model is superior to the competing methods in regards to option pricing during regime shifts.

Keywords: 2008 financial crisis, Parametric option pricing models, Non-parametric option pricing models, modular neural network-fuzzy learning vector quantization (MNN-FLVQ) model

Suggested Citation

Kukolj, Dragan and Gradojevic, Nikola and Lento, Camillo, Improving Non-Parametric Option Pricing during the Financial Crisis (August 5, 2012). Rimini Centre for Economic Analysis Working Paper No. 12-35. Available at SSRN: https://ssrn.com/abstract=2124534 or http://dx.doi.org/10.2139/ssrn.2124534

Dragan Kukolj

affiliation not provided to SSRN ( email )

Nikola Gradojevic (Contact Author)

University of Guelph, Department of Economics and Finance ( email )

50 Stone Road East
Guelph, Ontario N1G 2W1
Canada

HOME PAGE: http://https://www.uoguelph.ca/economics/users/nikola-gradojevic

University of Bologna - Rimini Center for Economic Analysis (RCEA) ( email )

Via Patara, 3
Rimini (RN), RN 47900
Italy

Camillo Lento

Lakehead University ( email )

955 Oliver Road
Thunder Bay, Ontario P7B 5E1
Canada

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