Which GARCH model for option valuation?

Which GARCH model for option valuation?

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Article ID: iaor20073753
Country: United States
Volume: 50
Issue: 9
Start Page Number: 1204
End Page Number: 1221
Publication Date: Sep 2004
Journal: Management Science
Authors: ,
Keywords: forecasting: applications
Abstract:

Characterizing asset return dynamics using volatility models is an important part of empirical finance. The existing literature on GARCH models favors some rather complex volatility specifications whose relative performance is usually assessed through their likelihood based on a time series of asset returns. This paper compares a range of GARCH models along a different dimension, using option prices and returns under the risk-neutral as well as the physical probability measure. We judge the relative performance of various models by evaluating an objective function based on option prices. In contrast with returns-based inference, we find that our option-based objective function favors a relatively parsimonious model. Specifically, when evaluated out-of-sample, our analysis favors a model that, besides volatility clustering, only allows for a standard leverage effect.

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