An empirical comparison of GARCH option pricing models

K. Hsieh () and P. Ritchken ()

Review of Derivatives Research, 2005, vol. 8, issue 3, 129-150

Abstract: Recent empirical studies have shown that GARCH models can be successfully used to describe option prices. Pricing such contracts requires knowledge of the risk neutral cumulative return distribution. Since the analytical forms of these distributions are generally unknown, computationally intensive numerical schemes are required for pricing to proceed. Heston and Nandi (2000) consider a particular GARCH structure that permits analytical solutions for pricing European options and they provide empirical support for their model. The analytical tractability comes at a potential cost of realism in the underlying GARCH dynamics. In particular, their model falls in the affine family, whereas most GARCH models that have been examined fall in the non-affine family. This article takes a closer look at this model with the objective of establishing whether there is a cost to restricting focus to models in the affine family. We confirm Heston and Nandi's findings, namely that their model can explain a significant portion of the volatility smile. However, we show that a simple non affine NGARCH option model is superior in removing biases from pricing residuals for all moneyness and maturity categories especially for out-the-money contracts. The implications of this finding are examined. Copyright Springer Science+Business Media, LLC 2005

Keywords: Testing GARCH models; Heston and Nandi model; NGARCH option models (search for similar items in EconPapers)
Date: 2005
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Citations: View citations in EconPapers (40)

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DOI: 10.1007/s11147-006-9001-3

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