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Loss Functions in Option Valuation: A Framework for Selection

Author

Listed:
  • Christian Wolff

    () (Luxembourg School of Finance, University of Luxembourg)

  • Dennis Bams

    () (Maastricht University)

  • Thorsten Lehnert

    () (Luxembourg School of Finance, University of Luxembourg)

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. We confirm the empirical results of Christoffersen and Jacobs (2004) and find strong evidence for their conjecture that the squared pricing error criterion may serve as a general purpose loss function in option valuation applications. At the same time, we provide 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 Root Mean Squared Pricing Error (RMSE), but a distribution.

Suggested Citation

  • Christian Wolff & Dennis Bams & Thorsten Lehnert, 2008. "Loss Functions in Option Valuation: A Framework for Selection," LSF Research Working Paper Series 08-11, Luxembourg School of Finance, University of Luxembourg.
  • Handle: RePEc:crf:wpaper:08-11
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    References listed on IDEAS

    as
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    9. Bams, Dennis & Lehnert, Thorsten & Wolff, Christian C.P., 2005. "An evaluation framework for alternative VaR-models," Journal of International Money and Finance, Elsevier, vol. 24(6), pages 944-958, October.
    10. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    11. Bernard Dumas & Jeff Fleming & Robert E. Whaley, 1998. "Implied Volatility Functions: Empirical Tests," Journal of Finance, American Finance Association, vol. 53(6), pages 2059-2106, December.
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    Citations

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    Cited by:

    1. Bekkour, Lamia & Jin, Xisong & Lehnert, Thorsten & Rasmouki, Fanou & Wolff, Christian, 2015. "Euro at risk: The impact of member countries' credit risk on the stability of the common currency," Journal of Empirical Finance, Elsevier, vol. 33(C), pages 67-83.
    2. Ryszard Kokoszczyński & Natalia Nehrebecka & Paweł Sakowski & Paweł Strawiński & Robert Ślepaczuk, 2010. "Option Pricing Models with HF Data – a Comparative Study. The Properties of Black Model with Different Volatility Measures," Working Papers 2010-03, Faculty of Economic Sciences, University of Warsaw.
    3. Frijns, Bart & Lehnert, Thorsten & Zwinkels, Remco C.J., 2011. "Modeling structural changes in the volatility process," Journal of Empirical Finance, Elsevier, vol. 18(3), pages 522-532, June.
    4. Thorsten Lehnert & Gildas Blanchard & Dennis Bams, 2014. "Evaluating Option Pricing Model Performance Using Model Uncertainty," LSF Research Working Paper Series 14-06, Luxembourg School of Finance, University of Luxembourg.
    5. Christian Wolff & Thorsten Lehnert & Cokki Versluis, 2009. "A Cumulative Prospect Theory Approach to Option Pricing," LSF Research Working Paper Series 09-03, Luxembourg School of Finance, University of Luxembourg.
    6. Kanniainen, Juho & Lin, Binghuan & Yang, Hanxue, 2014. "Estimating and using GARCH models with VIX data for option valuation," Journal of Banking & Finance, Elsevier, vol. 43(C), pages 200-211.
    7. Xisong Jin, 2018. "How much does book value data tell us about systemic risk and its interactions with the macroeconomy? A Luxembourg empirical evaluation," BCL working papers 118, Central Bank of Luxembourg.

    More about this item

    Keywords

    Option pricing; loss functions; estimation risk; GARCH; implied volatility;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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