Hedging derivative securities with genetic programming

Authors: Chen S-H.^{1, *}; Lee W-C.²; Yeh C-H.¹

Source: International Journal of Intelligent Systems in Accounting, Finance & Management, Volume 8, Number 4, December 1999 , pp. 237-251(15)

Publisher: John Wiley & Sons, Ltd.

Abstract:

One of the most recent applications of GP to finance is to use genetic programming to derive option pricing formulas. Earlier studies take the Black–Scholes model as the true model and use the artificial data generated by it to train and to test GP. The aim of this paper is to provide some initial evidence of the empirical relevance of GP to option pricing. By using the real data from S&P 500 index options, we train and test our GP by distinguishing the case in-the-money from the case out-of-the-money. Unlike most empirical studies, we do not evaluate the performance of GP in terms of its pricing accuracy. Instead, the derived GP tree is compared with the Black–Scholes model in its capability to hedge. To do so, a notion of tracking error is taken as the performance measure. Based on the post-sample performance, it is found that in approximately 20% of the 97 test paths GP has a lower tracking error than the Black–Scholes formula. We further compare our result with the ones obtained by radial basis functions and multilayer perceptrons and one-stage GP. Copyright © 1999 John Wiley & Sons, Ltd.

Keywords: option pricing; Black-Scholes model; genetic programming; tracking error

Language: English

Document Type: Research article

DOI: http://dx.doi.org/10.1002/(SICI)1099-1174(199912)8:4<237::AID-ISAF174>3.0.CO;2-J

Affiliations: 1: AI-ECON Research Group, Department of Economics, National Chengchi University, Taiwan 2: AI-ECON Research Group, Department of Finance and Banking, Tamsui Oxford University College, Taipie, Taiwan *

Publication date: 1999-12-01

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