Which Volatility Model Should Be Used for Option Pricing?
40 Pages Posted: 4 Mar 2002
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: Suggested Citation