A Hybrid Option Pricing Model Using a Neural Network for Estimating Volatility

Abstract

The Black-Scholes (BS) model is the standard approach used for pricing financial options. However, although being theoretically strong, option prices valued by the model often differ from the prices observed in the financial markets. This paper applies a hybrid neural network which preprocesses financial input data for improving the estimation of option market prices. This model is comprised of two parts. The first part is a neural network developed to estimate volatility. The second part is an additional neural network developed to value the difference between the BS model results and the actual market option prices. The resulting option price is then a summation between the BS model and the network response. The hybrid system with a neural network for estimating volatility provides better performance in terms of pricing accuracy than either the BS model with historical volatility (HV), or the BS model with volatility valued by the neural network.

Department(s)

Engineering Management and Systems Engineering

Keywords and Phrases

Black-Scholes; Hybrid Model; Non-Linear Systems; Option Pricing; Neural networks (Computer science)

International Standard Serial Number (ISSN)

0308-1079

Document Type

Article - Journal

Document Version

Citation

File Type

text

Language(s)

English

Rights

© 2007 Taylor & Francis, All rights reserved.

Publication Date

01 Jan 2007

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