Effectiveness of volatility models in option pricing: evidence from recent financial upheavals

Abstract

Purpose

The purpose of this paper is to explore the forecasting effectiveness of Black-Scholes (BS) focussing parity analysis of time series econometric and implied volatility (IV) numerical techniques.

Design/methodology/approach

To analyze the comparative competitiveness of econometric time series and IV models this paper consolidated the study with their inter-relations leading toward multilayered moneyness-maturity correlation of model and market option prices, thoroughly determined the moneyness-maturity combinations of error metrics of Nifty index options.

Findings

Out of six models tested and critically examined here, the paper procures only a single model, IV, which best caters to the requirements of option traders and as a result the paper ended up that only IV supports to multifarious moneyness-maturity dimension of option pricing of Nifty index options. The analysis also confirms that the standard VIX is not a reliable tool for determining the base price of Nifty index options (via BS). As the IV landmarks during the most dynamic phase of Indian capital market which is a touchstone to justify the quality of any model, the paper can deduce that IV could continue to perform in hardships of financial contraction par smoothly and effectively.

Practical implications

The final outcome of this research which ended successfully in exploring a dominant model, guided successfully through the most volatile period of Indian economy can be used to safe guard investor's faith and to figure a design which could compete on the canvass of option pricing.

Originality/value

As equity market is always subject to highly unpredictable conditions and may keep on experiencing it through all times to come, the unified objective of research is to find out the most impeccable volatility model to meet out the requirements of option practitioners, specifically contributing upto the satisfaction and expected results during tumultuous period.

Citation

Kumar Singh, V. (2013), "Effectiveness of volatility models in option pricing: evidence from recent financial upheavals", Journal of Advances in Management Research, Vol. 10 No. 3, pp. 352-375. https://doi.org/10.1108/JAMR-11-2012-0048