1. Risk-Neutral Density Extraction from Option Prices: Improved Pricing with Mixture Density Networks
- Author
-
Schittenkopf, Christian and Dorffner, Georg
- Subjects
Options (Finance) -- Prices and rates ,Pricing -- Analysis ,Hedging (Finance) -- Analysis ,Risk assessment -- Analysis ,Business ,Computers ,Electronics ,Electronics and electrical industries - Abstract
One of the central goals in finance is to find better models for pricing and hedging financial derivatives such as call and put options. We present a new semi-nonparametric approach to risk-neutral density extraction from option prices which is based on an extension of the concept of mixture density networks. The central idea is to model the shape of the risk-neutral density in a flexible, nonlinear way as a function of the time horizon. Thereby, stylized facts such as negative skewness and excess kurtosis are captured. The approach is applied to a very large set of intraday options data on the FTSE 100 recorded at LIFFE. It is shown to yield significantly better results in terms of out-of-sample pricing accuracy in comparison to the basic and an extended Black-Scholes model. It is also significantly better than a more elaborate GARCH option pricing model which includes a time-dependent volatility process. From the perspective of risk management, the extracted risk-neutral densities provide valuable information for Value-at-Risk estimations. Index Terms--Hedging, mixture density networks, options, pricing, risk-neutral densities.
- Published
- 2001