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Parameter estimation risk in asset pricing and risk management: A Bayesian approach

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  • Tunaru, Radu
  • Zheng, Teng

Abstract

Parameter estimation risk is non-trivial in both asset pricing and risk management. We adopt a Bayesian estimation paradigm supported by the Markov Chain Monte Carlo inferential techniques to incorporate parameter estimation risk in financial modelling. In option pricing activities, we find that the Merton's Jump-Diffusion (MJD) model outperforms the Black-Scholes (BS) model both in-sample and out-of-sample. In addition, the construction of Bayesian posterior option price distributions under the two well-known models offers a robust view to the influence of parameter estimation risk on option prices as well as other quantities of interest in finance such as probabilities of default. We derive a VaR-type parameter estimation risk measure for option pricing and we show that parameter estimation risk can bring significant impact to Greeks' hedging activities. Regarding the computation of default probabilities, we find that the impact of parameter estimation risk increases with gearing level, and could alter important risk management decisions.

Suggested Citation

  • Tunaru, Radu & Zheng, Teng, 2017. "Parameter estimation risk in asset pricing and risk management: A Bayesian approach," International Review of Financial Analysis, Elsevier, vol. 53(C), pages 80-93.
    • Handle: RePEc:eee:finana:v:53:y:2017:i:c:p:80-93
    DOI: 10.1016/j.irfa.2017.08.004
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    Cited by:

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    2. Mariano González-Sánchez & Eva M. Ibáñez Jiménez & Ana I. Segovia San Juan, 2022. "Market and model risks: a feasible joint estimate methodology," Risk Management, Palgrave Macmillan, vol. 24(3), pages 187-213, September.
    3. Lazar, Emese & Qi, Shuyuan, 2022. "Model risk in the over-the-counter market," European Journal of Operational Research, Elsevier, vol. 298(2), pages 769-784.
    4. Miguel Antonio Alba Suarez & Miguel Ángel Alba Acosta & David Camilo Alba Acosta, 2022. "Estimación bayesiana del modelo de difusión con saltos de Merton," Remef - Revista Mexicana de Economía y Finanzas Nueva Época REMEF (The Mexican Journal of Economics and Finance), Instituto Mexicano de Ejecutivos de Finanzas, IMEF, vol. 17(2), pages 1-32, Abril - J.

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    More about this item

    Keywords

    Parameter estimation risk; Bayesian option pricing; Greeks; Probability of default;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods

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