Index Option Pricing Models with Stochastic Volatility and Stochastic Interest Rates

This paper specifies a multivariate stochastic volatility (SV) model for the Samp;P500 index and spot interest rate processes. We first estimate the multivariate SV model via the efficient method of moments (EMM) technique based on observations of underlying state variables, and then investigate the respective effects of stochastic interest rates, stochastic volatility, and asymmetric Samp;P500 index returns on option prices. We compute option prices using both reprojected underlying historical volatilities and the implied risk premium of stochastic volatility to gauge each model?s performance through direct comparison with observed market option prices on the index. Our major empirical findings are summarized as follows. First, while allowing for stochastic volatility can reduce the pricing errors and allowing for asymmetric volatility or quot;leverage effectquot; does help to explain the skewness of the volatility 'smile', allowing for stochastic interest rates has minimal impact on option prices in our case. Second, similar to Melino amp; Turnbull (1990), our empirical findings strongly suggest the existence of a non zero risk premium for stochastic volatility of asset returns. Based on the implied volatility risk premium, the SV models can largely reduce the option pricing errors, suggesting the importance of incorporating the information from the options market in pricing options. Finally, both the model diagnostics and option pricing errors in our study suggest that the Gaussian SV model is not sufficient in modeling short-term kurtosis of asset returns, an SV model with fatter-tailed noise or jump component may have better explanatory power