Empirical performance of alternative option pricing models

Substantial progress has been made in developing more realistic option pricing models. Empirically, however, it is not known whether and by-how much each generalization improves option pricing and hedging. We fill this gap by first deriving an option model that allows volatility, interest rates and jumps' to be stochastic. Using S&P 500 options, we examine several alternative models from three perspectives: (1) internal consistency of implied parameters/volatility with relevant time-series data, (2) out-of-sample pricing, and (3) hedging. Overall, incorporating stochastic volatility and jumps is important for pricing and internal consistency. But for hedging, modeling stochastic volatility alone yields the best performance.