Appraising Model Complexity in Option Pricing

Mark Cummins and Francesco Esposito

Journal of Futures Markets, 2025, vol. 45, issue 5, 455-472

Abstract: The research question we consider is whether incremental complexity in option pricing models is justified by incremental model performance. We apply the model confidence set as a formal model comparison approach in appraising stochastic volatility jump‐diffusion option pricing models, spanning affine and nonaffine specifications. Jumps in price with stochastic (constant) arrival intensity produce superior (inferior) outcomes. A parsimonious negative exponential price jump distribution outperforms the popular normal distribution. Jumps in volatility (synchronized or not) worsen model performance. A parsimonious nonlinear hyperbolic drift extension of the Heston model performs particularly well. Nonlinear CEV models generally do not produce appreciable model performance.

Date: 2025
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https://doi.org/10.1002/fut.22575

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