Options and volatility

Because volatility of the underlying asset price is a critical factor affecting option prices and hedge ratios, the modeling of volatility and its dynamics is of vital interest to traders, investors, and risk managers. This modeling is a difficult task because the path of volatility during the life of an option is highly unpredictable. There has been a proliferation of volatility specifications since the original, simple constant-volatility assumption of the famous Black and Scholes option pricing model. This article gives an overview of different specifications of asset price volatility that are widely used in option pricing models. ; While the authors cite evidence that some stochastic-volatility option pricing models provide better market prices and hedges than the Black-Scholes model, they acknowledge that for both academic researchers and market practitioners, no consensus exists regarding the best specification of volatility for option pricing. Although a number of alternative approaches can account, at least partially, for the pricing deficiencies of the Black-Scholes models, none dominates as a clearly superior approach for pricing options.