Computational Management Science

, Volume 7, Issue 2, pp 189–206

American option pricing under stochastic volatility: an empirical evaluation

Original Paper

DOI: 10.1007/s10287-008-0083-2

Cite this article as:
AitSahlia, F., Goswami, M. & Guha, S. Comput Manag Sci (2010) 7: 189. doi:10.1007/s10287-008-0083-2

Abstract

Over the past few years, model complexity in quantitative finance has increased substantially in response to earlier approaches that did not capture critical features for risk management. However, given the preponderance of the classical Black–Scholes model, it is still not clear that this increased complexity is matched by additional accuracy in the ultimate result. In particular, the last decade has witnessed a flurry of activity in modeling asset volatility, and studies evaluating different alternatives for option pricing have focused on European-style exercise. In this paper, we extend these empirical evaluations to American options, as their additional opportunity for early exercise may incorporate stochastic volatility in the pricing differently. Specifically, the present work compares the empirical pricing and hedging performance of the commonly adopted stochastic volatility model of Heston (Rev Financial Stud 6:327–343, 1993) against the traditional constant volatility benchmark of Black and Scholes (J Polit Econ 81:637–659, 1973). Using S&P 100 index options data, our study indicates that this particular stochastic volatility model offers enhancements in line with their European-style counterparts for in-the-money options. However, the most striking improvements are for out-of-the-money options, which because of early exercise are more valuable than their European-style counterparts, especially when volatility is stochastic.

Keywords

Stochastic volatility Indirect inference Model calibration American option pricing S&P 100 index Approximate dynamic programming 

Copyright information

© Springer-Verlag 2008

Authors and Affiliations

  • Farid AitSahlia
    • 1
  • Manisha Goswami
    • 1
  • Suchandan Guha
    • 1
  1. 1.Department of Industrial and Systems Engineering, Weil Hall 303University of FloridaGainesvilleUSA

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