American Options under Stochastic Volatility: Parameter Estimation and Pricing Efficiency

Abstract

We present evidence that American option prices are insensitive to the accuracy of
spot and long–term volatility estimates in the Heston (1993) model, for which drastically
different parameter values can be obtained. Our results derive from a new accurate pricing
technique that we provide and which is based on a well-developed and efficient procedure
for the constant volatility model of Black and Scholes, requiring only 3 or 4 hyperplanes to
approximate the exercise surface. In addition, through an out–of–sample validation based
on S&P 100 data, we also show that our method generates prices close to market values.
In essence, our results contribute a practical illustration to the growing literature on model
mis-specification and robust pricing.