We compare option valuation models based on regime-switching, GARCH, and jump-diffusion processes to a
standard “smile” model, in which Black and Scholes (1973) implied volatilities are allowed to vary
across strike prices. The regime-switching, GARCH, and jump-diffusion models provide significant
improvement over a fixed smile model in fitting GBP and JPY option prices both in-sample and
out-of-sample. The jump-diffusion model achieves the tightest fit. A time-varying smile model,
however, provides hedging performance that is comparable to the other models for the GBP options.
This result suggests that standard option valuation techniques may provide a reasonable basis for
trading and hedging strategies.