Degree of Mispricing with the Black-Scholes Model and Nonparametric Cures |
Ramazan Gencay |
and |
Aslihan Salih |
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. |
Key Words: Option pricing; Nonparametric methods; Feedforward networks; Bayesian regularization; Early stopping; Bagging. |
JEL Classification Numbers: G0, G1. |