Empirical performance of alternative pricing models of currency options

This article examines the out-of-sample pricing performance and biases of t he Heston's stochastic volatility and modified Black-Scholes option pricing models in valuing European currency call options written on British pound. The modified Black-Scholes model with daily-revised implied volatilities p erforms as well as the stochastic volatility model in the aggregate sample. Both models provide close and similar correspondence to actual prices for options trading near- or at-the-money. The prices generated from the stocha stic volatility model are subject to fewer and weaker aggregate pricing bia ses than are the prices from the modified Black-Scholes model. Thus, the st ochastic volatility model may provide improved estimates of the measures of option price sensitivities to key option parameters that may lead to more effective hedging and speculative strategies using currency options. (C) 20 00 John Wiley & Sons, Inc.