Loss Functions in Option Valuation: A Framework for Model Selection
AbstractIn 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.
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Bibliographic InfoPaper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4960.
Date of creation: Mar 2005
Date of revision:
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Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
This paper has been announced in the following NEP Reports:
- NEP-ALL-2005-06-14 (All new papers)
- NEP-ECM-2005-06-14 (Econometrics)
- NEP-ETS-2005-06-14 (Econometric Time Series)
- NEP-FIN-2005-06-14 (Finance)
- NEP-FMK-2005-06-14 (Financial Markets)
- NEP-RMG-2005-06-14 (Risk Management)
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