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Degree of Mispricing with the Black-Scholes Model and Nonparametric Cures

Author

Listed:
  • Ramazan Gencay

    (Department of Economics, University of Windsor)

  • Aslihan Salih

    (Faculty of Business Administration, Bilkent University)

Abstract

The Black-Scholes pricing errors are larger in the deeper out-of-the-money options relative to the near out-of-the-money options, and mispricing worsens with increased volatility. Our results indicate that the Black-Scholes model is not the proper pricing tool in high volatility situations especially for very deep out-of-the-money options. Feedforward networks provide more accurate pricing estimates for the deeper out-of-the money options and handles pricing during high volatility with considerably lower errors for out-of-the-money call and put options. This could be invaluable information for practitioners as option pricing is a major challenge during high volatility periods.

Suggested Citation

  • 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.
    • Handle: RePEc:cuf:journl:y:2003:v:4:i:1:p:73-101
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Gradojevic Nikola, 2016. "Multi-criteria classification for pricing European options," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 20(2), pages 123-139, April.
    2. Ke Nian & Thomas F. Coleman & Yuying Li, 2018. "Learning minimum variance discrete hedging directly from the market," Quantitative Finance, Taylor & Francis Journals, vol. 18(7), pages 1115-1128, July.
    3. Nian, Ke & Coleman, Thomas F & Li, Yuying, 2021. "Learning sequential option hedging models from market data," Journal of Banking & Finance, Elsevier, vol. 133(C).
    4. Nikola Gradojevic, 2021. "Brexit and foreign exchange market expectations: Could it have been predicted?," Annals of Operations Research, Springer, vol. 297(1), pages 167-189, February.
    5. Anubha Srivastava & Manjula Shastri, 2020. "A Study of Black–Scholes Model’s Applicability in Indian Capital Markets," Paradigm, , vol. 24(1), pages 73-92, June.
    6. Nikola Gradojevic & Dragan Kukolj & Ramazan Gencay, 2011. "Clustering and Classification in Option Pricing," Review of Economic Analysis, Digital Initiatives at the University of Waterloo Library, vol. 3(2), pages 109-128, October.

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    More about this item

    Keywords

    Option pricing; Nonparametric methods; Feedforward networks; Bayesian regularization; Early stopping; Bagging;
    All these keywords.

    JEL classification:

    • G0 - Financial Economics - - General
    • G1 - Financial Economics - - General Financial Markets

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