While the stochastic volatility (SV) generalization has been shown to improve the explanatory power over the Black-Scholes model, empirical implications of SV models on option pricing have not yet been adequately tested. The purpose of this paper is to first estimate a multivariate SV model using the efficient method of moments (EMM) technique from observations of underlying state variables and then investigate the respective effect of stochastic interest rates, systematic volatility and idiosyncratic volatility on option prices | Pricing Stock Options under Stochastic Volatility and Interest Rates with Efficient Method of Moments Estimation George J. Jiang and Pieter J. van der Sluis 28th July 1999 George J. Jiang Department of Econometrics University of Groningen PO Box 800 9700 AV Groningen The Netherlands phone 31 50 363 3711 fax 31 50 363 3720 email 1 Pieter J. van der Sluis Department of Econometrics Tilburg University . Box 90153 NL-5000 LE Tilburg The Netherlands phone 31 13 466 2911 email sluis@. This paper was presented at the Econometric Institute in Rotterdam Nuffield College at Oxford CORE Louvain-la-Neuve and Tilburg University. 1 Abstract While the stochastic volatility SV generalization has been shown to improve the explanatory power over the Black-Scholes model empirical implications of SV models on option pricing have not yet been adequately tested. The purpose of this paper is to first estimate a multivariate SV model using the efficient method of moments EMM technique from observations of underlying state variables and then investigate the respective effect of stochastic interest rates systematic volatility and idiosyncratic volatility on option prices. We compute option prices using reprojected underlying historical volatilities and implied stochastic volatility risk to gauge each model s perfomiance through di rec t comparison with observed market option prices. Our major empirical findings are summarized as follows. First while theory predicts that the short-term interest rates are strongly related to the systematic volatility of the consumption process our estimation results suggest that the short-term interest rate fails to be a good proxy of the systematic volatility factor Second while allowing for stochastic volatility can reduce the pricing errors and allowing for asymmetric volatility or leverage effect does help to explain the skewness of the volatility smile allowing for stochastic interest rates has minimal impact on option prices
