Pricing FTSE 100 index options under stochastic volatility

The autoregressive conditional heteroscedasticity/generalized autoregressiv e conditional heteroscedasticity (ARCH/GARCH) literature and studies of imp lied volatility clearly show that volatility changes over time, This articl e investigates the improvement in the pricing of Financial Times-Stock Exch ange (FTSE) 100 index options when stochastic volatility is taken into acco unt. The major tool for this analysis is Heston's (1993) stochastic volatil ity option pricing formula, which allows for systematic volatility risk and arbitrary correlation between underlying returns and volatility The result s reveal significant evidence of stochastic volatility implicit in option p rices, suggesting that this phenomenon is essential to improving the perfor mance of the Black-Scholes model (Black & Scholes, 1973) for FTSE 100 index options. (C) 2001 John Wiley & Sons, Inc.