Volatility Long Memory on Option Valuation: Component Garch versus Fractionally Integrated GARCH
37 Pages Posted: 24 Jul 2009 Last revised: 19 Nov 2009
Date Written: July 23, 2009
Volatility long memory is a stylized fact that has been documented for a long time. Existing literature have two ways to model volatility long memory: component volatility models and fractionally integrated volatility models. This paper develops a new fractionally integrated GARCH model, and investigates its performance by using the Standard and Poor’s 500 index returns and cross-sectional European option data. The fractionally integrated GARCH model significantly outperforms the simple GARCH(1, 1) model by generating 37% less option pricing errors. With stronger volatility persistence, it also dominates a component volatility model, who has enjoyed a reputation for its outstanding option pricing performance, by generating 15% less option pricing errors. We also confirm the fractionally integrated GARCH model’s robustness with the latest option prices. This paper indicates that capturing volatility persistence represents a very promising direction for future study.
Keywords: option valuation, long memory, fractional integration, NGARCH, long-run
JEL Classification: C22,G13
Suggested Citation: Suggested Citation