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Appraising model complexity in option pricing

  • Mark Cummins*
  • , Francesco Esposito
  • *Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

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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.
Original languageEnglish
Pages (from-to)455-472
Number of pages18
JournalJournal of Futures Markets
Volume45
Issue number5
Early online date26 Feb 2025
DOIs
Publication statusPublished - 1 May 2025

Keywords

  • affine and nonaffine jump-diffusion model specifications
  • model complexity
  • model confidence set
  • option pricing models
  • stochastic volatility

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