Title: On different pricing approaches for options under GARCH with non-normal innovations
Authors: Lars Stentoft - University of Western Ontario (Canada) [presenting]
Abstract: Two different pricing frameworks are typically used in the literature when pricing options under GARCH with non-normal innovations: the equilibrium approach and the no-arbitrage approach. Each framework can accommodate various forms of GARCH and innovation distributions, but empirical implementation and tests are typically done in one framework or the other because of the computational challenges that are involved in obtaining the relevant pricing parameters. We contribute to the literature by comparing and documenting the empirical performance of a GARCH specification which can be readily implemented in both pricing frameworks. The model uses a parsimonious GARCH specification with skewed and leptokurtic Johnson $s_u$ innovations together with either the equilibrium based framework or the no-arbitrage based framework. Using a large sample of options on the S\&P 500 index, we find that the two approaches give rise to very similar pricing errors when implemented with time-varying pricing parameters. However, when implemented with constant pricing parameters, the performance of the no-arbitrage approach deteriorates in periods of high volatility relative to the equilibrium approach whose performance remains stable and at par with the models with time-varying pricing parameters.