The Value of Multivariate Model Sophistication: An Application to pricing Dow Jones Industrial Average Options

Abstract

We assess the predictive accuracy of a large number of multivariate volatility models in terms of pricing options on the Dow Jones Industrial Average. We measure the value of model sophistication in terms of dollar losses by considering a set 248 multivariate models that differ in their specification of the conditional variance, conditional correlation, and innovation distribution. All models belong to the dynamic conditional correlation class which is particularly suited because it allows to consistently estimate the risk neutral dynamics with a manageable computational effort in relatively large scale problems. It turns out that the most important gain in pricing accuracy comes from increasing the sophistication in the marginal variance processes (i.e. nonlinearity, asymmetry and component structure). Enriching the model with more complex correlation models, and relaxing a Gaussian innovation for a Laplace innovation assumption improves the pricing in a smaller way. Apart from investigating directly the value of model sophistication in terms of dollar losses, we also use the model confidence set approach to statistically infer the set of models that delivers the best pricing performance.