Which Volatility Model Should Be Used for Option Pricing?

40 Pages Posted: 4 Mar 2002

See all articles by Kris Jacobs

Kris Jacobs

University of Houston - C.T. Bauer College of Business

Peter Christoffersen

University of Toronto - Rotman School of Management; Copenhagen Business School; Aarhus University - CREATES

Abstract

Characterizing asset return dynamics using GARCH models is an important part of empirical finance. The existing literature favors some rather complex volatility specifications whose relative performance is usually assessed through their likelihood based on a time-series of asset returns. This paper compares a range of GARCH models along a different dimension, using option prices and returns, under the risk-neutral as well as the objective probability measure. We judge the relative performance of various models by evaluating an objective function based on option prices. In contrast with likelihood-based inference, we find that our option-based objective function favors a relatively parsimonious model. Specifically, when evaluated out-of-sample, our analysis favors a model that besides volatility clustering only allows for a standard leverage effect. This empirical analysis is part of a growing literature suggesting that discrete-time option pricing with time-varying volatility is practical and insightful. Our results may also have important implications for the literature on continuous-time stochastic volatility models.

Keywords: Option Pricing, GARCH, Risk-neutral Pricing, Parsimony, Forecasting, Out-of-sample

JEL Classification: G12

Suggested Citation

Jacobs, Kris and Christoffersen, Peter, Which Volatility Model Should Be Used for Option Pricing?. EFA 2002 Berlin Meetings Discussion Paper. Available at SSRN: https://ssrn.com/abstract=302175 or http://dx.doi.org/10.2139/ssrn.302175

Kris Jacobs (Contact Author)

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Peter Christoffersen

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5P 3C4
Canada
416-946-5511 (Phone)

Copenhagen Business School

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

Aarhus University - CREATES

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

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