Comparative analysis of machine learning and traditional models for financial option pricing

This study conducts a comparative analysis of traditional and machine learning models for financial option pricing, using historical stock prices and interest rates data. Traditional models such as the Black-Scholes, Heston, Merton Jump-Diffusion, and GARCH are evaluated against machine learning models including Multi-Layer Perceptrons (MLPs) and Long Short-Term Memory (LSTM) networks. The analysis employs performance metrics like Mean Squared Error (MSE), Mean Absolute Error (MAE), Root Mean Squared Error (RMSE), and R value. Results indicate that the GARCH model excels in predictive accuracy due to its ability to capture volatility clustering, while machine learning models, especially the Tuned Neural Network, demonstrate superior flexibility and adaptability in managing complex non-linear relationships in financial data. Traditional models, although theoretically robust, show limitations under varying market conditions. The study underscores the potential of hybrid approaches combining traditional and machine learning techniques to leverage their respective strengths for more accurate and reliable option pricing. Future research directions include exploring advanced machine learning architectures and improving model transparency through explainable AI.

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Publication Details

Journal
Applied and Computational Engineering
Published
2024-09-10
DOI
https://doi.org/10.54254/2755-2721/88/20241650
Primary Topic
Stock Market Forecasting Methods
Type
article
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article

Comparative analysis of machine learning and traditional models for financial option pricing

Zhibo Wang
Applied and Computational Engineering
Stock Market Forecasting Methods
article

Comparative analysis of machine learning and traditional models for financial option pricing

Zhibo Wang
article en

Abstract

This study conducts a comparative analysis of traditional and machine learning models for financial option pricing, using historical stock prices and interest rates data. Traditional models such as the Black-Scholes, Heston, Merton Jump-Diffusion, and GARCH are evaluated against machine learning models including Multi-Layer Perceptrons (MLPs) and Long Short-Term Memory (LSTM) networks. The analysis employs performance metrics like Mean Squared Error (MSE), Mean Absolute Error (MAE), Root Mean Squared Error (RMSE), and R value. Results indicate that the GARCH model excels in predictive accuracy due to its ability to capture volatility clustering, while machine learning models, especially the Tuned Neural Network, demonstrate superior flexibility and adaptability in managing complex non-linear relationships in financial data. Traditional models, although theoretically robust, show limitations under varying market conditions. The study underscores the potential of hybrid approaches combining traditional and machine learning techniques to leverage their respective strengths for more accurate and reliable option pricing. Future research directions include exploring advanced machine learning architectures and improving model transparency through explainable AI.

Applied and Computational EngineeringVol. 88(1)
University of Manchester (GB)
Openalex Percentile: Top 82%
Stock Market Forecasting Methods
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Comparative analysis of machine learning and traditional models for financial option pricing — Zhibo Wang · Applied and Computational Engineering (2024) | TGRS Research Map | TGRS