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Implications of parameter uncertainty on option prices

Lindström, Erik LU (2010) In Advances in Decision Sciences 2010. p.1-15
Abstract
Financial markets are complex processes where investors interact

to set prices. We present a framework for option valuation under imperfect

information, taking risk neutral parameter uncertainty into account. The

framework is a direct generalization of the existing valuation methodology.

Many investors base their decisions on mathematical models that have been

calibrated to market prices. We argue that the calibration process introduces

a source of uncertainty that needs to be taken into account. The models

and parameters used may differ to such extent that one investor may find an

option under-priced whereas another investor may find the very same option

... (More)
Financial markets are complex processes where investors interact

to set prices. We present a framework for option valuation under imperfect

information, taking risk neutral parameter uncertainty into account. The

framework is a direct generalization of the existing valuation methodology.

Many investors base their decisions on mathematical models that have been

calibrated to market prices. We argue that the calibration process introduces

a source of uncertainty that needs to be taken into account. The models

and parameters used may differ to such extent that one investor may find an

option under-priced whereas another investor may find the very same option

over-priced. This problem is not taken into account by any of the standard

models.

The paper is concluded by presenting simulations and an empirical study

on FX options where we demonstrate improved predictive performance (in

sample and out of sample) using this framework. (Less)
Please use this url to cite or link to this publication:
author
organization
publishing date
type
Contribution to journal
publication status
published
subject
in
Advances in Decision Sciences
volume
2010
pages
1 - 15
publisher
Hindawi Publishing Corporation
external identifiers
  • scopus:80051606293
ISSN
2090-3359
DOI
10.1155/2010/598103
language
English
LU publication?
yes
id
b128b0ea-69c2-4c08-bc12-a4349ecc9087 (old id 1546401)
date added to LUP
2010-02-23 12:32:33
date last changed
2018-05-29 09:42:49
@article{b128b0ea-69c2-4c08-bc12-a4349ecc9087,
  abstract     = {Financial markets are complex processes where investors interact<br/><br>
to set prices. We present a framework for option valuation under imperfect<br/><br>
information, taking risk neutral parameter uncertainty into account. The<br/><br>
framework is a direct generalization of the existing valuation methodology.<br/><br>
Many investors base their decisions on mathematical models that have been<br/><br>
calibrated to market prices. We argue that the calibration process introduces<br/><br>
a source of uncertainty that needs to be taken into account. The models<br/><br>
and parameters used may differ to such extent that one investor may find an<br/><br>
option under-priced whereas another investor may find the very same option<br/><br>
over-priced. This problem is not taken into account by any of the standard<br/><br>
models.<br/><br>
The paper is concluded by presenting simulations and an empirical study<br/><br>
on FX options where we demonstrate improved predictive performance (in<br/><br>
sample and out of sample) using this framework.},
  author       = {Lindström, Erik},
  issn         = {2090-3359},
  language     = {eng},
  pages        = {1--15},
  publisher    = {Hindawi Publishing Corporation},
  series       = {Advances in Decision Sciences},
  title        = {Implications of parameter uncertainty on option prices},
  url          = {http://dx.doi.org/10.1155/2010/598103},
  volume       = {2010},
  year         = {2010},
}