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Clustering and Classification in Option Pricing

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  • Nikola Gradojevic

    (Lakehead University, The Rimini Center for Economic Analysis)

  • Dragan Kukolj

    (University of Novi Sad)

  • Ramazan Gencay

    (Simon Fraser University, The Rimini Center for Economic Analysis)

Abstract

This paper reviews the recent option pricing literature and investigates how clustering and classification can assist option pricing models. Specifically, we consider non-parametric modular neural network (MNN) models to price the S&P-500 European call options. The focus is on decomposing and classifying options data into a number of sub-models across moneyness and maturity ranges that are processed individually. The fuzzy learning vector quantization (FLVQ) algorithm we propose generates decision regions (i.e., option classes) divided by ÔintelligentÕ classification boundaries. Such an approach improves generaliza- tion properties of the MNN model and thereby increases its pricing accuracy.

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Bibliographic Info

Article provided by Rimini Centre for Economic Analysis in its journal Review of Economic Analysis.

Volume (Year): 3 (2011)
Issue (Month): 2 (October)
Pages: 109-128

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Handle: RePEc:ren:journl:v:3:y:2011:i:2:p:109-128

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Related research

Keywords: Option Pricing; Clustering; Parametric Methods; Non-parametric Methods; Fuzzy Logic;

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References

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  1. Diebold, Francis X & Mariano, Roberto S, 2002. "Comparing Predictive Accuracy," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(1), pages 134-44, January.
  2. Peter Carr & Liuren Wu, 2002. "Time-Changed Levy Processes and Option Pricing," Finance 0207011, EconWPA.
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  4. Nikola Gradojevic & Ramazan Gencay & Dragan Kukolj, 2009. "Option Pricing with Modular Neural Networks," Working Paper Series 32_09, The Rimini Centre for Economic Analysis, revised Jan 2009.
  5. Bakshi, Gurdip & Cao, Charles & Chen, Zhiwu, 2000. "Pricing and hedging long-term options," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 277-318.
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  16. Ole E. Barndorff-Nielsen & Neil Shephard, 2001. "Non-Gaussian Ornstein-Uhlenbeck-based models and some of their uses in financial economics," Journal of the Royal Statistical Society Series B, Royal Statistical Society, vol. 63(2), pages 167-241.
  17. Ramazan Gencay & Aslihan Salih, 2003. "Degree of Mispricing with the Black-Scholes Model and Nonparametric Cures," Annals of Economics and Finance, Society for AEF, vol. 4(1), pages 73-101, May.
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