A 'Horse Race' Among Competing Option Pricing Models Using S&P 500 Index Options

34 Pages Posted: 24 Mar 2008

See all articles by Minqiang Li

Minqiang Li

Bloomberg LP

Neil D. Pearson

University of Illinois at Urbana-Champaign - Department of Finance

Date Written: February 1, 2007

Abstract

The last three decades have witnessed a whole array of option pricing models. We compare the predictive performances of a selection of models by carrying out a horse race on S&P 500 index options along the lines of Jackwerth and Rubinstein (2001). The models we consider include: Black-Scholes, trader rules, Heston's stochastic volatility model, Merton's jump diffusion models with and without stochastic volatility, and more recent Levy type models. Trader rules still dominate mathematically more sophisticated models, and the performance of the trader rules is further improved by incorporating the stable index skew pattern documented in Li and Pearson (2005). Furthermore, after incorporating the stable index skew pattern, the Black-Scholes model beats all mathematically more sophisticated models in almost all cases. Mathematically more sophisticated models vary in their overall performance and their relative accuracy in forecasting future volatility levels and future volatility skew shapes.

Keywords: option pricing models, performance comparison, implied skew

JEL Classification: G12, G13

Suggested Citation

Li, Minqiang and Pearson, Neil D., A 'Horse Race' Among Competing Option Pricing Models Using S&P 500 Index Options (February 1, 2007). Available at SSRN: https://ssrn.com/abstract=952770 or http://dx.doi.org/10.2139/ssrn.952770

Minqiang Li (Contact Author)

Bloomberg LP ( email )

731 Lexington Avenue
New York, NY 10022
United States

Neil D. Pearson

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States
217-244-0490 (Phone)
217-244-9867 (Fax)

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