Pricing American options with stochastic volatility: Evidence from S&P 500 futures options

✍ Scribed by Lim Kian Guan; Guo Xiaoqiang

• Publisher: John Wiley and Sons
• Year: 2000
• Tongue: English
• Weight: 228 KB
• Volume: 20
• Category: Article
• ISSN: 0270-7314
• DOI: 10.1002/1096-9934(200008)20:7<625::aid-fut2>3.0.co;2-m

✦ Synopsis

This article is the first attempt to test empirically a numerical solution to price American options under stochastic volatility. The model allows for a mean-reverting stochastic-volatility process with non-zero risk premium for the volatility risk and correlation with the underlying process. A general solution of risk-neutral probabilities and price movements is derived, which avoids the common negative-probability problem in numerical-option pricing with stochastic volatility. The empirical test shows clear evidence supporting the occurrence of stochastic volatility. The stochastic-volatility model outperforms the constant-volatility model by producing smaller bias and better goodness of fit in both the in-sample and out-of-sample test. It not only eliminates systematic moneyness bias produced by the constant-volatility model, but also has better prediction power. In addition, both models Financial support from the Institute of High Performance Computing is gratefully acknowledged. We also wish to thank the two reviewers for useful comments.