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The value of multivariate model sophistication: An application to pricing Dow Jones Industrial Average options

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  • Rombouts, Jeroen
  • Stentoft, Lars
  • Violante, Franceso
Abstract
We assess the predictive accuracies of a large number of multivariate volatility models in terms of pricing options on the Dow Jones Industrial Average. We measure the value of model sophistication in terms of dollar losses by considering a set of 444 multivariate models that differ in their specification of the conditional variance, conditional correlation, innovation distribution, and estimation approach. All of the models belong to the dynamic conditional correlation class, which is particularly suitable because it allows consistent estimations of the risk neutral dynamics with a manageable amount of computational effort for relatively large scale problems. It turns out that increasing the sophistication in the marginal variance processes (i.e., nonlinearity, asymmetry and component structure) leads to important gains in pricing accuracy. Enriching the model with more complex existing correlation specifications does not improve the performance significantly. Estimating the standard dynamic conditional correlation model by composite likelihood, in order to take into account potential biases in the parameter estimates, generates only slightly better results. To enhance this poor performance of correlation models, we propose a new model that allows for correlation spillovers without too many parameters. This model performs about 60% better than the existing correlation models we consider. Relaxing a Gaussian innovation for a Laplace innovation assumption improves the pricing in a more minor way. In addition to investigating the value of model sophistication in terms of dollar losses directly, we also use the model confidence set approach to statistically infer the set of models that delivers the best pricing performances.

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  • Rombouts, Jeroen & Stentoft, Lars & Violante, Franceso, 2014. "The value of multivariate model sophistication: An application to pricing Dow Jones Industrial Average options," International Journal of Forecasting, Elsevier, vol. 30(1), pages 78-98.
    • Handle: RePEc:eee:intfor:v:30:y:2014:i:1:p:78-98
    DOI: 10.1016/j.ijforecast.2013.07.006
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    Cited by:

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    2. Carlo Drago & Andrea Scozzari, 2022. "Evaluating conditional covariance estimates via a new targeting approach and a networks-based analysis," Papers 2202.02197, arXiv.org.
    3. Carlo Drago & Andrea Scozzari, 2023. "A Network-Based Analysis for Evaluating Conditional Covariance Estimates," Mathematics, MDPI, vol. 11(2), pages 1-19, January.
    4. de Almeida, Daniel & Hotta, Luiz K. & Ruiz, Esther, 2018. "MGARCH models: Trade-off between feasibility and flexibility," International Journal of Forecasting, Elsevier, vol. 34(1), pages 45-63.
    5. Geert Dhaene & Piet Sercu & Jianbin Wu, 2022. "Volatility spillovers: A sparse multivariate GARCH approach with an application to commodity markets," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 42(5), pages 868-887, May.
    6. Bollerslev, Tim & Patton, Andrew J. & Quaedvlieg, Rogier, 2020. "Multivariate leverage effects and realized semicovariance GARCH models," Journal of Econometrics, Elsevier, vol. 217(2), pages 411-430.

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    More about this item

    Keywords

    Option pricing; Economic loss; Forecasting; Multivariate GARCH; Model confidence set;
    All these keywords.

    JEL classification:

    • C10 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - General
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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