Loss Functions in Option Valuation: A Framework for Model Selection

Christian Wolff, Dennis Bams and Thorsten Lehnert

No 4960, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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. 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.

Keywords: Option pricing; Loss functions; Estimation risk; Garch; Implied volatility (search for similar items in EconPapers)
JEL-codes: G12 (search for similar items in EconPapers)
Date: 2005-03
New Economics Papers: this item is included in nep-ecm, nep-ets, nep-fin, nep-fmk and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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