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Simulation-based Estimation of Contingent-claims Prices

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Author Info
Peter C.B. Phillips () (Cowles Foundation, Yale University)
Jun Yu (Singapore Management University)

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Abstract

A new methodology is proposed to estimate theoretical prices of financial contingent-claims whose values are dependent on some other underlying financial assets. In the literature the preferred choice of estimator is usually maximum likelihood (ML). ML has strong asymptotic justification but is not necessarily the best method in finite samples. The present paper proposes instead a simulation-based method that improves the finite sample performance of the ML estimator while maintaining its good asymptotic properties. The methods are implemented and evaluated here in the Black-Scholes option pricing model and in the Vasicek bond pricing model, but have wider applicability. Monte Carlo studies show that the proposed procedures achieve bias reductions over ML estimation in pricing contingent claims. The bias reductions are sometimes accompanied by reductions in variance, leading to significant overall gains in mean squared estimation error. Empirical applications to US treasury bills highlight the differences between the bond prices implied by the simulation-based approach and those delivered by ML. Some consequences for the statistical testing of contingent-claim pricing models are discussed.

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Publisher Info
Paper provided by Cowles Foundation, Yale University in its series Cowles Foundation Discussion Papers with number 1596.

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Length: 30 pages
Date of creation: Jan 2007
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Handle: RePEc:cwl:cwldpp:1596

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Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA

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Related research
Keywords: Bias reduction; Bond pricing; Indirect inference; Option pricing; Simulation-based estimation;

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Find related papers by JEL classification:
C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - Statistical Simulation Methods
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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