This paper investigates the consequences of stochastic volatility for pricing the KOSPI 200 stock index call options. For the empirical purpose, we examines the stochastic volatility model suggested by Heston(1993). The parameters of Heston's mean-reverting square-root stochastic volatility model are estimated in the time-series approach. The parameter estimates are then used to price the KOSPI 200 stock index call options and the predictions are compared to observed market prices.
The result shows that the model tends to underprice in-the-money calls and overprice out-of-the-money calls. We also find that by allowing volatility to be stochastic, it results in a more accurate predictions of observed option prices, especially, in the out-of-the-money calls.
