Specification Analysis of Option Pricing Models Based on Time-Changed Lévy Processes


  • Jing-zhi Huang,

  • Liuren Wu

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    • Huang is from Smeal College of Business, Penn State University. Wu is from Zicklin School of Business, Baruch College (CUNY). We are grateful to Rick Green (the editor), an anonymous referee, Menachem Brenner, Peter Carr, Robert Engle, Steve Figlewski, Martin Gruber, Jean Helwege, Chenghu Ma, Ernst Schaumburg, Marti Subrahmanyam, and Rangarajan Sundaram for helpful comments and discussions. We thank seminar participants at Baruch College, the University of Notre Dame, Salomon Smith Barney, Washington University in St. Louis, the 2003 European Finance Association meetings, and the 2004 Winter Econometric Society meetings, for helpful comments. We also thank Sandra Sizer Moore for her editing.


We analyze the specifications of option pricing models based on time-changed Lévy processes. We classify option pricing models based on the structure of the jump component in the underlying return process, the source of stochastic volatility, and the specification of the volatility process itself. Our estimation of a variety of model specifications indicates that to better capture the behavior of the S&P 500 index options, we need to incorporate a high frequency jump component in the return process and generate stochastic volatilities from two different sources, the jump component and the diffusion component.