Appraising model complexity in option pricing

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Cummins, Mark and Esposito, Francesco (2025) Appraising model complexity in option pricing. Journal of Futures Markets. ISSN 0270-7314 (https://doi.org/10.1002/fut.22575)

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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.

ORCID iDs

Cummins, Mark ORCID logoORCID: https://orcid.org/0000-0002-3539-8843 and Esposito, Francesco;
CORE (COnnecting REpositories)