SABR equipped with AI wings

Hideharu Funahashi

Quantitative Finance, 2023, vol. 23, issue 2, 229-249

Abstract: This study proposes an artificial neural network (ANN) based option pricing framework under the SABR (stochastic alpha beta rho) and free boundary SABR volatility models. Unlike previous research, we do not directly apply the ANN technique to train and predict option implied volatilities. Instead, we use the technique to train and predict the differences between the implied volatilities calculated by asymptotic approximation and those computed by Monte Carlo simulation. Since the analytical solution for an option written on an underlying asset price in the SABR model is intractable, approximation techniques are used to derive an approximate closed-form solution in practice. However, these approximation formulas worsen as maturity increases and the underlying asset's volatility is high. The accuracy decreases rapidly in wings, which represents deep in-the-money and out-of-the-money cases. By combining the approximation formulas and ANN framework, our new option pricing method offers the following improvements: (1) the training becomes more robust, and the predictions produce more stable and accurate results: (2) it significantly speeds up the training procedure: and (3) the accuracy and efficiency of approximation are improved in the wings without sacrificing performance.

Date: 2023
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DOI: 10.1080/14697688.2022.2150561

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