Loss Functions in Option Valuation: A Framework for Model Selection
22 Pages Posted: 22 Jul 2004
There are 2 versions of this paper
Loss Functions in Option Valuation: A Framework for Model Selection
Loss Functions in Option Valuation: A Framework for Model Selection
Date Written: February 2004
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.
Keywords: Option pricing, loss functions, estimation risk, GARCH, implied volatility
JEL Classification: G12
Suggested Citation: Suggested Citation
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