Title: Pricing Chinese warrants using artificial neural networks coupled with Markov regime switching model

Authors: David Liu; Lei Zhang

Addresses: Department of Mathematical Sciences, Xi'an Jiaotong Liverpool University, Higher Educational Town, Suzhou, Jiangsu Province, 215123, China. ' Department of Mathematical Sciences, Xi'an Jiaotong Liverpool University, Higher Educational Town, Suzhou, Jiangsu Province, 215123, China

Abstract: A non-parametric valuation framework (ANN-MRS) using artificial neural networks for pricing financial derivatives has been developed whilst the volatility of underlying asset return dynamics are modelled by Markov regime switching model. Its immediate application is on pricing of the Chinese warrants. To access the potential of neural network pricing with volatility in regime switching, weekly data of Jiangtong Stock returns are used to calculate the volatilities by using the maximum likelihood estimation. The ability of neural network for predicting the warrant prices is compared to the Black-Scholes model. Comparisons reveal that the mean squared error for the neural network is less than that of the Black-Scholes model in both in sample and out of sample estimations. The result indicates the neural network model coupled with Markov regime switching (for volatility estimation) has a superior performance comparing the warrant pricing by using the Black-Scholes model with historical volatility.

Keywords: warrant pricing; Markov regime switching; artificial neural networks; ANNs; Chinese warrants; China; derivatives pricing; volatility; asset return dynamics.

DOI: 10.1504/IJFMD.2011.045600

International Journal of Financial Markets and Derivatives, 2011 Vol.2 No.4, pp.314 - 330

Available online: 27 Feb 2012 *

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