Empirical Performance of Alternative Option Pricing Models

Posted: 6 Mar 1997

See all articles by Zhiwu Chen

Zhiwu Chen

University of Hong Kong; Yale University - International Center for Finance; Zebra Capital Management, LLC

Charles Cao

Pennsylvania State University

Gurdip Bakshi

Fox School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: December 1996


Substantial progress has been made in extending the Black- Scholes model to incorporate such features as stochastic volatility, stochastic interest rates and jumps. On the empirical front, however, it is not yet known whether and by how much each generalized feature will improve option pricing and hedging performance. This paper fills this gap by first developing an implementable option model in closed form that allows volatility, interest rates and jumps to be stochastic and that is parsimonious in the number of parameters. The model includes many known ones as special cases. Delta- neutral and single-instrument minimum-variance hedging strategies are derived analytically. Using S&P 500 options, we examine a set of alternative models from three perspectives: (1) internal consistency of implied parameters/ volatility with relevant time-series data, (2) out-of-sample pricing and (3) hedging performance. The models of focus include the benchmark Black-Scholes formula and the ones that respectively allow for (i) stochastic volatility, (ii) both stochastic volatility and stochastic interest rates, and (iii) stochastic volatility and jumps. Overall, incorporating both stochastic volatility and random jumps produces the best pricing performance and the most internally-consistent implied-volatility process. Its implied volatility does not "smile" across moneyness. But, for hedging, adding either jumps or stochastic interest rates does not seem to improve performance any further once stochastic volatility is taken into account.

JEL Classification: G10, G12, G13

Suggested Citation

Chen, Zhiwu and Cao, Charles and Bakshi, Gurdip S., Empirical Performance of Alternative Option Pricing Models (December 1996). Available at SSRN: https://ssrn.com/abstract=8162

Zhiwu Chen

University of Hong Kong ( email )

Pokfulam Road
Hong Kong

Yale University - International Center for Finance ( email )

Box 208200
New Haven, CT 06520-8200
United States
203-432-5948 (Phone)
203-432-6970 (Fax)

Zebra Capital Management, LLC ( email )

612 Wheelers Farms Road
Milford, CT 06461
United States

Charles Cao (Contact Author)

Pennsylvania State University ( email )

Department of Finance
Smeal College of Business
University Park, PA 16802
United States
814-865-7891 (Phone)
814-865-3362 (Fax)

HOME PAGE: http://www.personal.psu.edu/qxc2/cao.html

Gurdip S. Bakshi

Fox School of Business ( email )

Department of Finance
Philadelphia, PA 19022
United States
215-204-6117 (Phone)
tuk40718@temple.edu (Fax)

HOME PAGE: http://https://sites.google.com/view/gurdipbakshi1

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