Price Bias and Common Practice in Option Pricing

41 Pages Posted: 9 Aug 2018

See all articles by Jean-François Bégin

Jean-François Bégin

Simon Fraser University

Geneviève Gauthier

HEC Montreal - Department of Decision Sciences; HEC Montreal - Department of Management Sciences

Date Written: July 24, 2018

Abstract

Generally, the semiclosed-form option pricing formula for complex financial models depends on unobservable factors such as stochastic volatility and jump intensity. A popular practice is to use an estimate of these latent factors to compute the option price. However, in many situations, this plug-and-play approximation does not yield the appropriate price. This paper examines this bias and quantifies its impacts. We decompose the bias into terms that are related to the bias on the unobservable factors and to the precision of their point estimators. The approximated price is found to be highly biased when only the history of the stock price is used to recover the latent states. This bias is corrected when option prices are added to the sample used to recover the states’ best estimate. We also show numerically that such a bias is propagated on calibrated parameters, leading to erroneous values.

Keywords: option pricing, jump-diffusions, model calibration, estimation bias, information set

JEL Classification: C13, C19

Suggested Citation

Bégin, Jean-François and Gauthier, Genevieve, Price Bias and Common Practice in Option Pricing (July 24, 2018). Available at SSRN: https://ssrn.com/abstract=3219499 or http://dx.doi.org/10.2139/ssrn.3219499

Jean-François Bégin (Contact Author)

Simon Fraser University ( email )

8888 University Drive
Burnaby, British Columbia V5A 1S6
Canada

HOME PAGE: http://www.sfu.ca/~jbegin

Genevieve Gauthier

HEC Montreal - Department of Decision Sciences ( email )

3000 Côte-Sainte-Catherine Road
Montreal, QC H2S1L4
Canada

HEC Montreal - Department of Management Sciences ( email )

Montreal, Quebec H3T 2A7
Canada

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