GARCH vs. stochastic volatility: Option pricing and risk management

In this paper we compare the out-of-sample performance of two common extensions of the Black-Scholes option pricing model, namely GARCH and stochastic volatility (SV). We calibrate the three models to intraday FTSE 100 option prices and apply two sets of performance criteria, namely out-of-sample valuation errors and Value-at-Risk (VaR) oriented measures. When we analyze the fit to observed prices, GARCH clearly dominates both SV and the benchmark Black-Scholes model. However, the predictions of the market risk from hypothetical derivative positions show sizable errors. The fit to the realized profits and losses is poor and there are no notable differences between the models. Overall, we therefore observe that the more complex option pricing models can improve on the Black-Scholes methodology only for the purpose of pricing, but not for the VaR forecasts. (C) 2002 Elsevier Science B.V. All rights reserved.